Main focus of this report is Impact of Basel II Accord Implementation in 2009 on Capital Adequacy and Risk Management of The HSBC Limited, Bangladesh. Here allover discussion of the Basel II accord and the requirements under this accord and explain about the adoption of Basel II accord by Bangladesh Bank will affect the capital adequacy situation and existing risk management process of HSBC Bangladesh. Finally determine the level of preparedness of HSBC Bangladesh to meet the new requirements and find out the steps the bank should take to minimize these effects.
Various newspaper articles published in the last few months reveal that Bangladesh Bank, the regulator of the banking industry in Bangladesh, is planning to implement the Basel II accord for the banks in Bangladesh from 2009. Basel II is an effort by international banking supervisors to update the original international bank capital accord (Basel I), which has been in effect since 1988 (in Bangladesh since 1996). Basel II reflects the latest round of deliberations by central bankers held in Basel, Switzerland, where they agreed to ensure uniformity in the way banks and banking regulations approach risk management across national borders. The Basel-II Capital Accord titled “International Convergence of Capital Measurement and Capital Standards: A Revised Framework” has been published by the Bank for International Settlement (BIS) in November 2005 for adoption globally.
The new accord, though complex, carries a lot of virtues and will be a milestone in improving commercial banks’ internal mechanism and supervisory process. It will be beneficial to the commercial banks, as it requires review and measurement of different types of risk, which ultimately have effect on risk management approach to comply with the accord standards. Once implemented, banks would also be benefited with significant improvements in their risk management systems, business models, capital strategies and disclosure standards as well as overall efficiency. At present, Bangladesh is following Basel-I for banks’ capital adequacy requirement, wherein risk-weighted capital adequacy ratio was 8 per cent when it was first adopted in 1996. Later in 2002, the ratio was increased to 9 per cent. The idea of the new framework is to strengthen risk-based requirements by laying out principles for banks to assess the adequacy of their capital. It will also enable the supervisors to review such assessments to make sure that banks have adequate capital to support their risks. It also seeks to strengthen market discipline by enhancing transparency in banks’ financial reporting.
The new Basel accord has been prepared on the basis of three pillars: minimum capital requirement, supervisory review process and market discipline. Three types of risks — credit risk, market risk and operational risk — have to be considered under the minimum capital requirement. For credit risk measurement, new framework provides two different methods – standardized approach and internal ratings-based approach. Implementation of standardized approach requires credit assessment intuitions or rating agencies for determining capital requirements of the banks in line with the Basel fixed risk-weight. On the other hand, internal rating based approach allows banks to rate their credit risks, which again have two different approaches — foundation approach and advanced approach.
However, implementation of Basel II at individual bank’s level is not likely to be an easy task. It will require training for the banking professionals, investment in hard and soft infrastructure and high level professional skill in risk management system implementation. More importantly, it may increase the banks’ capital requirement as the banks’ risk weighted capital adequacy ratio may fall because of more stringent risk assessment and higher risk weights.
This report provides a brief overview of the prevailing status and conditions of the banking sector in Bangladesh in line with Basel II requirements. However, this study has mainly concentrated on the implementation aspects of Pillar I, which has three components such as credit risk, operational risk and market risk. In fact, this study has further narrowed down its scope to focus on different approaches for the measurement of capital charge against credit risk and operational risk and seeks to answer the following questions: (a) What kinds of challenges are likely to be faced by both the Bangladesh Bank and the scheduled banks (including HSBC Bangladesh) in adopting different approaches to credit risk and operational risk? (b) Which approaches are likely to be more appropriate for Bangladesh to measure and charge capital against those risks?
This report tried to achieve the following objectives:
- Give a brief overview of the Basel II accord and the requirements under this accord.
- Analyze the advantages and disadvantages of the options available under Basel II to assess different types of risks and predict which methods are likely to be adopted by Bangladesh Bank for implementation by the scheduled banks in Bangladesh.
- Analyze how the adoption of Basel II accord by Bangladesh Bank will affect the capital adequacy position and existing risk assessment process of HSBC Bangladesh
- Determine the level of preparedness of HSBC Bangladesh to meet the new requirements and find out the steps the bank should take to minimize these effects.
The report used both secondary data and primary data. Secondary data was collected and used to provide overview of the Basel II accord and the requirements under this accord, the changes introduced in measuring credit risk, market risk and operational risk etc. Secondary data was also used to determine the suitability of the various alternative risk assessment approaches for implementation in Bangladesh and their likelihood of being selected by Bangladesh Bank. Primary research was done to find out the impact of the proposed changes on capital requirement and risk assessment process of HSBC Bangladesh.
Primary data was collected by interviewing concerned officials of the bank in the Financial Control, Credit Risk Management, Operations and Corporate Banking Divisions of HSBC Bangladesh.
The secondary data was collected partly from the Basel II accord itself, i.e. “International Convergence of Capital Measurement and Capital Standards: A Revised Framework” published by the Bank for International Settlement (BIS). Additional data was collected from various newspaper articles, internet articles and Bangladesh Bank publications on the accord. Some data was also collected from the HSBC Group’s intranet to find out the Group’s planned strategy in meeting Basel II requirements.
Data Collection Method
For the organization part and secondary data for the research part, information was collected from different published articles, journals, reports and brochures on HSBC. Primary data for the research part was collected through interviewing the relevant officials of the bank. However, no formal questionnaire for data collection will be used.
An Overview of HSBC Group
The HSBC Group is named after its founding member, The Hongkong and Shanghai Banking Corporation Limited, which was established in 1865 in Hong Kong and Shanghai to finance the growing trade between China and Europe.
Thomas Sutherland, a Hong Kong Superintendent of the Peninsular and Oriental Steam Navigation Company helped to establish this bank in March 1865. Throughout the late nineteenth and the early twentieth centuries, the bank established a network of agencies and branches based mainly in China and South East Asia but also with representation in the Indian sub-continent, Japan, Europe and North America.
The post-war political and economic changes in the world forced the bank to analyze its strategy for continued growth in the 1950s. The bank diversified both its business and its geographical spread through acquisitions and alliances.
HSBC Holdings plc, the parent company of the HSBC Group, was established in 1991 with its shares quoted on both the London and Hong Kong stock exchanges. The HSBC Group now comprises a unique range of banks and financial service providers around the globe.
HSBC maintains one of the world’s largest private data communication networks and is reconfiguring its business for the e-age. Its rapidly growing e-commerce capability includes the use of the internet, PC banking over a private network, interactive TV, and fixed and mobile, including wireless application protocol or WAP-enabled mobile, telephones.
Foundation and Growth
The inspiration behind the founding of the bank was Thomas Sutherland, a Scot who was then working as the Hong Kong Superintendent of the Peninsular and Oriental Steam Navigation Company. He realized that there was considerable demand for local banking facilities both in Hong Kong and along the China coast and he helped to establish the bank in March 1865. Then, as now, the bank’s headquarters were at 1 Queen’s Road Central in Hong Kong and a branch was opened one month later in Shanghai.
Throughout the late nineteenth and the early twentieth centuries, the bank established a network of agencies and branches based mainly in China and South East Asia but also with representation in the Indian sub-continent, Japan, Europe and North America. In many of its branches the bank was the pioneer of modern banking practices. From the outset, trade finance was a strong feature of the bank’s business with bullion, exchange and merchant banking also playing an important part. Additionally, the bank issued notes in many countries throughout the Far East.
During the Second World War the bank was forced to close many branches and its head office was temporarily moved to London. However, after the war the bank played a key role in the reconstruction of the Hong Kong economy and began to further diversify the geographical spread of the bank.
The post-war political and economic changes in the world forced the bank to analyze its strategy for continued growth in the 1950s. The bank diversified both its business and its geographical spread through acquisitions and alliances. This strategy culminated in 1992 with one of the largest bank acquisitions in history when HSBC Holdings acquired the UK’s Midland Bank plc (now called HSBC Bank plc). However, it remained committed to its historical markets and played an important part in the reconstruction of Hong Kong where its branch network continued to expand.
The HSBC Group at present
HSBC Holdings is a public limited company incorporated in England and Wales. Headquartered in London, the HSBC group operates in five regions: Europe; Hong Kong; the rest of Asia Pacific; including the Middle East and Africa; North America; and South America. The entities which form the HSBC Group provide a comprehensive range of financial services to personal, commercial, corporate, institutional and investment, and private banking clients. To more easily promote the Group as a whole, HSBC was established as a uniform, international brand name in 1999. In 2002, HSBC launched a campaign to differentiate its brand from those of its competitors by describing the unique characteristics which distinguish HSBC, summarized by the words ‘The world’s local bank’.
Banks under the HSBC Group
Many of the members of the group have changed their name into HSBC (The Hong Kong and Shanghai Banking Corporation Limited) to introduce the whole group under one brand name.
Midland Bank, one of the principal UK clearing banks, was acquired by HSBC Holdings in 1992. The bank has a personal customer base of five and a half million, business customers of over half a million, and a network of almost 1,700 branches in the United Kingdom. Midland has offices in 28 countries and territories, principally in continental Europe, with a number of offices in Latin America.
Hang Seng Bank, in which HongkongBank has a 62.1% equity interest, maintains a network of 146 branches in the Hong Kong SAR, where it is the second-largest locally incorporated bank after HongkongBank. Hang Seng Bank also has a branch in Singapore and four branches in China.
Marine Midland Bank, headquartered in Buffalo, New York, has 380 banking locations state-wide. The bank serves over two million personal customers and 120,000 commercial and institutional customers in New York State and, in selected businesses, throughout the United States.
Hongkong Bank of Canada is the largest foreign-owned bank in Canada and the country’s seventh-largest bank. It has 116 branches across Canada and two branches in the western United States.
Banco HSBC Bamerindus was established in Brazil in 1997. The bank has its head office in Curitibank and a network of some 1,900 branches and sub-branches, the second largest in Brazil.
Hongkong Bank Malaysia is the largest foreign-owned bank in Malaysia and the country’s fifth-largest bank, with 36 branches.
The British Bank of the Middle East (British Bank) is the largest and most widely represented international bank in the Middle East, with 31 branches throughout the United Arab Emirates, Oman, Bahrain, Qatar, Jordan, Lebanon and the Palestinian Autonomous Area, including an offshore banking unit in Bahrain. The bank also has branches in Mumbai and Trivandrum, India, and Baku, Azerbaijan, as well as private banking operations in London and Geneva.
HSBC Banco Roberts was acquired in 1997. Based in Buenos Aires, it is one of Argentina’s largest privately owned banks, with 60 branches throughout the country.
HongkongBank of Australia has 16 branches across Australia. It is the flagship of the HSBC Group’s businesses there, operating under the name HSBC Australia, and providing a complete range of financial services.
The Saudi British Bank, a 40%-owned member of the HSBC Group, has 63 branches throughout Saudi Arabia and a branch in London.
Other associated Group banks are British Arab Commercial Bank, The Cyprus Popular Bank and Egyptian British Bank. Wells Fargo HSBC Trade Bank is a San Francisco-based joint venture between HSBC and Wells Fargo Bank, providing trade finance and international banking services in the United States through its offices in five western states and in conjunction with Wells Fargo’s 32 regional commercial banking offices in 10 western states. In addition, the Group has a non-equity strategic alliance with Wells Fargo Bank, which provides access to a wide range of banking services through that bank’s more than 1,900-staffed outlets. The Group also has a non-equity alliance with Wachovia Corporation, one of the leading corporate banks in the United States, with business relationships in 50 states.
The HSBC Asia Pacific group represents HSBC in Bangladesh. HSBC opened its first branch in Dhaka in 17th December, 1996 to provide personal banking services, trade and corporate services, and custody services. The Bank was awarded ISO9002 accreditation for its personal and business banking services, which cover trade services, securities and safe custody, corporate banking, Hexagon and all personal banking. This ISO9002 designation is the first of its kind for a bank in Bangladesh. The HongKong and Shanghai Banking Corporation Bangladesh Ltd. primarily limited its operations to help garments industry and to commercial banking. Later, it extended its services to pharmaceuticals, jute and consumer products. Other services include cash management, treasury, securities, and custodial service.
Realizing the huge potential and growth in personal banking industry in Bangladesh, HSBC extended its operation to the personal banking sector in Bangladesh and within a very short span of time it was able to build up a huge client base. Extending its operation further, HSBC opened a branch at Chittagong, three branch offices at Dhaka (Gulshan, Mothijheel and Dhanmondi) and an offshore banking unit on November 1998.
HSBC Bangladesh is under strict supervision of HSBC Asia Pacific Group, Hong Kong. The Chief Executive Officer of HSBC Bangladesh manages the whole banking operation of HSBC in Bangladesh. Under the CEO there are heads of departments who manage specific banking functions e.g. personal banking, corporate banking, etc.
Currently HSBC Bangladesh is providing a wide range of services both two individual and corporate level customers. In the year 2000, the bank launched a wide array of personal banking products designed for all kinds of (middle and higher-middle income) individual customers. Some such products were Personal loans, car loans, etc. Recently the bank launched three of its personal banking products – Tax loan, Personal secured loan & Automated Tele Banking (ATB) service. These products are designed to meet the diverse customer needs more completely.
HSBC in Bangladesh also specializes in self-service banking through providing 24-hour ATM services. Recently it has introduced Day & Night banking by installing Easy-pay machines in Banani, Uttara and Dhanmondi to better satisfy the needs of both customers and non-customers. In total HSBC currently has 10 ATMs and 3 Easy-pay machines located at various geographical areas of Dhaka & Chittagong.
Different Activities in Bangladesh
As one of the largest international banks in Bangladesh, HSBC has a long-term commitment to its customers and provides a comprehensive range of financial services: personal, commercial and corporate banking; trade services; cash management; treasury; consumer & business finance; and securities and custody services.
Personal Banking Services
HSBC offers a full range of personal banking products and services designed to take care of its customers’ growing needs and requirements. HSBC in Bangladesh has launched a number of loan products during 2000. Personal Installment Loan is an unsecured loan that does not require any personal guarantee or cash security; Car Loan, also, does not require any down payment or personal guarantee. The Bank has already launched Phone banking, a state-of-the-art automated telephone banking service available 24 hours a day, 7 days a week, and 365 days a year, which allows customers to access their account from the comfort of the office or home. HSBC is the market leader in the local Auto-Pay service with which the company can initiate bulk Taka payments to, or Taka collections from, any HSBC current or savings accounts of counterparts for a specified sum at a specified date, regardless of the branch. HSBC also offers Power-Vantage, a unique all-in-one package of products and services designed to give total financial control to the customer; a unique savings account, which allows the customer to do any number of transactions without any charges being incurred or credit interest lost. To satisfy the growing needs of real estate HSBC Bangladesh recently launched Home Loan Scheme and a special type of deposit product named “Bangladesh International” for non-resident Bangladeshi. Details of these products and more will be discussed later.
Corporate Banking Services
HSBC offers a wide range of cash financing, working capital, short and medium-term loans and guarantee facilities from its Head Office and Chittagong branch. The Offshore Banking Unit (OBU) provides US Dollar denominated working capital as well as short-term finance for capital imports to eligible businesses. Using high-speed communication links, HSBC connects customers to international payment systems.
As the leading provider of trade finance and related services to importers and exporters in Asia, HSBC in Bangladesh operates a highly automated trade-processing network and offers an Electronic Data Interchange (EDI) capability through Hexagon. The Bank also uses SWIFT, an efficient and secure mechanism for bank-to-bank global communications used for all trade related activities including fund transfers and issuance of DC’s (Documentary Credit).
HSBC provides global trade services and cash management services to local banks. HSBC’s worldwide network strength, with over 9500 offices in 76 countries and territories, coupled with a world class reputation in Trade Finance (“Best Trade Documentation Bank” – Euro money) places HSBC in an ideal position to render unmatched correspondent banking services.
HSBC’s commanding presence in the USA (5th largest USD clearing bank globally), UK (largest GBP clearing bank globally), and the Euroland (largest Euro clearing bank in the UK) allows the Bank to also provide first class cash management solutions in 3 major global currencies; USD, GBP and Euro.
Payments and Cash Management
HSBC was the pioneer in introducing electronic cash management solutions in Bangladesh, by introducing its state-of-the-art proprietary software, Hexagon, back in 1997. This was initially made available to corporate clients only but has since been expanded to include banks and retail clients.
With Hexagon, the Bank’s cash management system, corporate customers can access banking services from anywhere in the world to view account balances and statements, make transfers and international payments, and to open documentary credits, by using only a PC, a modem and a telephone line.
Functional Departments of HSBC
HSBC activities are performed through functional departmentalization. So, the departments are separated according to the functions they perform. Within the major departments there are some other subsidiary departments that allow smooth operation of their own major departmental function.
Personal Banking / Personal Financial Services (PFS)
PFS is the most flourishing department of HSBC Bangladesh. This department basically deals with the management of products and services offered to the individual consumers. Within a span of only five years, HSBC PFS has grown tremendously and is still growing with its innovative products and service offerings. PFS Head Mr. Mamoon Mahmud Shah manages this department. PFS Head manages and supervises the Personal Banking activities of the branch network of HSBC Bangladesh. The branches and booths of HSBC basically deal with the personal banking activities and provide various accounts services to individual customers.
Operations of PFS
Manages daily operation
- Plans and directs sales and marketing
- Plans for service development
- Top-level authority for customers’ dealings and transaction
- Provides required service to the customers directly
- Maintains documentation and report flow vary rapidly
- Helps in planning in field level
- Assists PFS Head in decision-making process
- Assists PFS Head in different level of research
- Assists PFS Head day-to-day work
- Keeps track and inform PFS Head in present condition of the competition in the market
There are eight branches of HSBC. Only the Dhaka office (head office) branch & Chittagong branch deals with both corporate and personal banking. The other offices only deal with the personal banking activities. There functions are to provide various financial services to the consumers. These include customer services, sale of various PFS products, opening new accounts, providing cash, remittance and other teller services, etc. The branches are quite decentralized for better delivery of services to customer and have their own premises and facilities. These branches are headed by branch managers. Each branch is staffed with its own team of employees. A great deal of teamwork is seen within these branches. ATM’s are situated with each branch premises.
The ATM center ensures smooth operation of the ATM machines. The ATM center is responsible for regular replenishment of the off-site ATM’s and servicing of all the ATMs. Currently a total 16 ATMs are in operation. The ATM center also deals with issuance, termination and servicing of the ATM cards. On a whole, the ATM center is the department that is solely responsible for all the activities related to ATM and is the facilitating department that enables customers 24 hour banking support.
This department is under the same manager as the ATM center. They basically deal with all the buying and selling of government bonds and treasury bills as per customer instruction, i.e. BSP, PSP, TSP etc. This department keeps under its control the transactions regarding USDB, USDIB and WEDB.
ATB refers to Automated Tele Banking. This department deals with the back office servicing of the HSBC phone banking services provided to customers. This department is basically responsible for the activation of ATB, ATB pin generation, and ATB security management, ATB blocking and troubleshooting of all ATB problems. This department is fairly new and was constructed on January 2001. Currently this department is staffed with one executive and one officer.
PFS Credit Department
The personal banking credit department deals with the consumer credit schemes such as the Personal loan, Car loan, Travel Loan, Personal Secured loan, etc. which are tailored to meet the demand of individual customers. The manager of PFS credit who approves and administers all the activities heads this department. He is staffed with one loan approval officer, one loan processing officer, two assistant officers and one MIS clerk. The approval officer mainly rejects or approves the credit requests. After being checked by the approval officer, the credit requests go to the processing officer for further processing of the application. This department is a member of ALCO (Asset Liability Management Committee), which coordinates in preparation of lending analysis and data on concentration of risk and identifies possible lending risks. This department is also responsible for monitoring all necessary documents and securities related to loans.
This division if HSBC provides financial services to organizational (corporate) clients. HSBC is a worldwide leader in banking and financial services whose success is based on its relationships with its corporate clients. Whether it is locally or around the world, HSBC offers a comprehensive range of services that can be tailored to the individual needs of the company. The Head of this department is the Chief of Corporate Banking. He is also the Vice-CEO of HSBC Bangladesh. The chief of Corporate Banking manages the activities of corporate banking of HSBC Bangladesh. Two offices of HSBC Bangladesh offer corporate banking services to corporate clients. These are the Dhaka Head Office and Chittagong office. Corporate Banking of HSBC Bangladesh includes Corporate Institutional Banking (CIB), Trade Service (HTV), and Hexagon. These sub-divisions are discussed briefly in the following sections along with a structure chart of Corporate Banking division of HSBC Bangladesh.
Services Department of HSBC
This is an integral and vital part of the bank. The services department ensures smooth operation and functioning within and between all the departments of HSBC. It also provides continuous support to the core banking activities of HSBC. The Manager of Services heads this department who formulates and manages various critical issues of the services function of HSBC. He is followed by a group of executives who are the heads of various subsidiary divisions that operate within the services department. The services department is considered as the backbone of all other departments. The various subsidiary divisions within this department are Administration, IT, Internal Control (IC), Network Services Center (NSC), and HUB. A briefing of the subsidiary divisions is presented below:
Like that of any other organizations, the Admin department of HSBC makes sure that the organizations moves on with all its departments and staffs operating according to all the rules and regulations of the company. It also prevents any bottlenecks within the work process and ensures smooth functioning. The admin department has two divisions – General Administration and Business Support Services.
The general admin division is pretty much similar to the admin departments of other companies that ensure discipline and regulatory concerns. The business support services provide supports to the departments during employee leaves and sudden terminations so that the department can function without problems.
Information Technology (IT)
This department gives the software and hardware supports to different departments of the bank. As HSBC is engaged in online banking, the role of IT is very crucial for the bank. This department is the most active department of HSBC where employees always stand by to solve any problems in the system. The managers and executives of IT division work continuously to develop the total IT system of HSBC so that it can be operated with ease, accuracy and speed.
HSBC has internal auditors who visit on regular basis and submit the report to the higher authority for audit purposes. This gives different departments the chance to know their mistakes and take necessary corrective actions. Again, the Bank annually administers a company wide audit program to evaluate the overall performance of the bank in Bangladesh.
HSBC Universal Banking (HUB)
The HSBC banking system is called HUB. HSBC does the online banking and it is HUB, which sets up the parameter for that. This HUB is linked with the HSBC group via satellite and each and every transaction made by HSBC within Bangladesh is being recorded at the HSBC Asia-pacific headquarters at Hong Kong via HUB. Thus the HUB is the most powerful and important equipment of HSBC Bangladesh that monitors and tracks any fraud and faults made with HSBC Bangladesh.
Network Services Center (NSC)
This department can be described as the ‘Power House’ of HSBC Bangladesh. NSC does the back office job for the bank. The main four jobs that are performed by NSC are Clearing, Scanning of signature cards, issuing checkbooks and sending & receiving Remittances. NSC looks after the clearing process of HSBC and makes necessary contact with the central bank for maintaining account flows. All the customer signatures are scanned in this department and are entered into the system. NSC also issues checkbook for new and old accounts based on requisition from various branches. ‘Remittance’ is a banking term, which means ‘Transfer of funds through banks’. When a bank remits on behalf of its customers, it is termed as outward remittance. On the other hand, when the bank receives the remittance on behalf of the bank, it is inward remittance. The following are the methods that NSC used to remit money for customers: Telegraphic Transfer (TT), Demand Draft (DD) & Cashier’s Order.
Human Resource Department
The Human Resource Manager heads this department. The major functions of this department are strategic planning and policy formulation for Compensation, Recruitment, Promotion, Training and developments, Personnel Services and Security. The HR department is very much concerned with the discipline that is set up by the HSBC group. HSBC group has got strict rules and regulations for each and every aspect of banking, even for non-banking purposes; i.e. The Dress Code. All these major personnel functions are integrated in the best possible way at HSBC, which results in its higher productivity. The Human resource officer monitors the employee staffing and administration activities. The Training officer supervises Training, development & rotation activities.
These are the major departments of HSBC Bangladesh. Except the branches all other departments are situated at HSBC Bangladesh head offices located at Anchor Tower, Kawran Bazar. Most of HSBC’s operations and activities are operated centrally from the head office. But to deal with customers more completely, the branches are given considerable authority and they operate in a more decentralized manner but subject to verification of the respective departments.
Introduction to Capital Adequacy and Basel Accords
Capital adequacy (CA) is defined as the minimum level of capital, which is required to protect a bank from portfolio losses. The concept of CA is very important in the banking industry as capital acts as the safeguard against depositors’ funds. Banks run primarily on depositors’ funds – they have the authority to mobilize deposits and lend the same. As such, they expose public deposits to potential credit risks and must take appropriate measures to minimize these credit risks through proper risk management systems. Capital acts as the cushion against any unforeseen losses arising market risks (interest rate risk, exchange rate risk, market price risk etc), operational risks and credit risks.
Bank owners are required to put in adequate capital:
- To act as a cushion between depositors’ funds and loans made by the bank
- To absorb any unforeseen losses arising from credit and other risks
- Otherwise, depositors’ funds will be depleted with every loss.
But capital is only a supplementary arrangement for risk management and not a substitute. Hence, risk management should not be neglected even if there is adequate excess capital. Poor risk management can wipe out the entire capital of a bank and lead to collapse of the bank.
However, debate on the quantum of minimum level of capital required seems to be never ending. Though different methods and approaches were adopted in different points in time, they were insufficient to capture new dimensions and magnitudes of risk emanated from the continuous innovations in the domestic and international business. Consequently the 1970s and 80s experienced many uncertainties and volatilities that caused serious banking problems. The prevailing approach that a bank’s capital should be linked to a fixed ratio of its time and demand liabilities went under strong criticism on the ground that bank’s major risk is derived from the riskiness of its assets. The Basel Committee, based on this idea, designed Capital Regulation in 1988, which is known as the Basel Accord I.
The Basel Committee on Banking Supervision is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten countries in 1975. It consists of senior representatives of bank supervisory authorities and central banks from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and the United States. The name of the committee has been derived from the location of its permanent Secretariat at the Bank for International Settlements (BIS) in Basel, Switzerland.
Basel I accord requires banks to maintain a Regulatory Capital (RC) of not less than 8% (9% in Bangladesh), in relation to their total credit risk, measured on the basis of aggregated risk weighted value of their:
- On balance sheet exposure (all assets other than riskfree assets, such as cash, Treasury bills etc)
- Off balance sheet exposure (commitments & contingencies such as LCs)
In 1996, the RC requirement was extended to cover market risk as well.
Hence, Basel I can be summarized as follows:
Regulatory Capital Adequacy Ratio (RCAR) = [(Tier I + Tier II) – deductions]/[Credit Risk (= Risk weighted assets+ Contingencies) + Market risk] X 100 > =9%
Shortfall in RCAR is not permitted under this accord. However, excess in RCAR is always encouraged as it has many advantages as follows:
- Having the minimum 9% capital adequacy (CA) means that the bank can take a hit upto 9% of its RC without endangering depositors’ funds.
- Any excess over 9% CA enhances the bank’s loss sustaining capacity
- It also indicates the size of the capital buffer available for future growth
- Regarded as symbol of financial stability
- Facilitates higher credit ratings for banks (CA is the 1st pillar in CAMEL rating)
Thus the Basel I accord established a direct relationship between the total risk profile and the RC of the bank Hence risk assets expansion of a bank is required to be backed by adequate growth in RC. Not only the capital expenditure or overseas expansion projects, but the entire risk-asset creation process of banks, including their lending, has to be backed by capital. Therefore, ebem the normal organic growth of a bank has to be backed by RC.
If we look at the components of the RCAR, we see that the denominator, i.e. total risk profile of the bank increases with the growth in business volumes. Unless the numerator, i.e. RC too increases at the same pace, the RCAR falls. But this kind of growth is not possible, unless the bank has excess RC. Even in situations where the bank has excess RC, this kind of growth would reduce the RCAR.
Banks are compelled to curtail their risk asset growth in instances where:
- There is not enough excess RC or
- They are unable to raise the required capital
- Funds have been raised through low cost deposits
- There is a demand for good quality advances.
The Basel I Accord:
Two fundamental objectives of the Accord were (a) to strengthen the soundness and stability of the international banking system and (b) to obtain a high degree of consistency in its application to banks in different countries with a view to diminishing an existing source of competitive inequality among international banks. To that end, the accord requires that banks meet a minimum capital ratio that must be equal to at least 8 percent of total risk-weighted assets.
If judged by the extent to which it has been taken up around the world, the 1988 Basel Capital Accord (“Basel I”) was a great success: it has been implemented as the capital adequacy standard for banks by more than 100 countries. A relatively simple measure of capital adequacy, Basel I has been adopted not only by the leading industrialized nations, but also by middle income and developing countries, including most in Asia.
The original accord was intended to apply to internationally active banks with the aim of shoring up bank capital levels globally while also promoting a more “level playing field” so that weakly capitalized institutions from one country would not have a competitive advantage over its better capitalized competitors that needed to charge higher interest rates to achieve an adequate return on capital.
Weaknesses in Basel I Accord
Despite its many merits, the Accord has been widely criticized for its failure to achieve the stated objectives. Since it introduced risk-based capital requirement, which was adopted by many developed and developing countries as well, it was expected that the Accord would help to strengthen financial system stability and reduce banking and financial crises. On the contrary, banking crises again occurred in 1990s even in some robust economies of East Asia.
Basel I has been effective in raising capital levels globally. It was clear from the beginning, however, that the accord had weaknesses, mostly with respect to its crude measurement of a bank’s credit risk exposure. There was no customer wise assessment of risk. In stead, all exposures were classified into a few broad risk brackets based on either “due from whom” or “collateral held” and a standard set of risk weights applied on groups as follows:
Table: Risk Weights used under Basel I Accord
|Due from Govt./ Central Bank or against their guarantees||0%|
|Against the security of Govt. debt||0%|
|Against cash / gold||0%|
|Due from Banks or against their guarantees||20%|
|Primary mortgages against residential properties||50%|
|All other advances||100%|
|All other assets||100%|
Hence, most advances were risk graded at a flat rate of 100%, irrespective of their credit worthiness and totally disregarding whether they are:
- Corporate or small industry
- Short-term or long-term
- High risk or low risk
- AAA rated or hard-core/non-performing
The 8% charge (or 100% risk-weight) applied to almost all corporate credits is an excessively broad brush approach. This provided very little incentives for the banks to improve risk management. As all advances were subject to same capital charge, cost of capital became flat for all loans (irrespective of risk) and there were no capital incentives for good quality lending. Over time, this treatment has generated some perverse incentives, notably for banks to sell off high quality assets and retain exposures to higher risk, lower quality borrowers, since both are subject to the same 8% charge. This could even lead to under-pricing of risky loans and denial of price advantage to good quality borrowers.
Rodriguez (2002) and others argue that the use of arbitrary risk categories and arbitrary weights that bear no relation to default rates incorrectly assume that all assets within one category are equally risky. The risk assessment methodology is flawed in the sense that it assumes a portfolio’s total risk is equal to the sum of the risks of the individual assets in the portfolio. No account is taken of portfolio management strategies, which can greatly reduce the overall risk of a portfolio, or of the size of a portfolio, which can greatly influence its total risk profile. Collaterals other than cash, government guarantees and government debt was not given any consideration also.
The accord gives preferential treatment to government securities, which are considered risk-free. The sovereign debt defaults of Russia in the summer of 1998 and Argentina in early 2002 demonstrated that government debt is not a risk free investment. Other criticisms include that the accord sets capital standards only for credit risk (i.e., the risk of counterparty failure), but not for other types of risk such as operational risk and market risk. Consequently, capital requirement was not reflective of economic risk. It has not provided enough incentive for risk management, risk mitigation and innovation in risk management such as arbitrage opportunities through securitization.
The use of securitization posed a particular problem for regulators, as it provided a mechanism for banks to “arbitrage” their regulatory ratios. By securitizing high quality assets and keeping the subordinated tranche of their issues (e.g. 20% of the amount securitized) the banks were in effect retaining the bulk of the credit risk, yet this risk was not being fully reflected in their Basel I ratios. Another example is the Basel I use of membership in the Organization for Economic Cooperation and Development (OECD) as a basis for determining a country’s creditworthiness, with OECD bank and sovereign lending benefiting from lower capital charges. An anomaly became increasingly apparent as banks from certain OECD members, such as Mexico, Turkey and Korea, attracted lower charges than banks from better-rated and hence lower-risk non-OECD countries such as Hong Kong and Singapore.
When the Accord was formalized, no consensus and consultation were taken from the representatives of the developing nations. Therefore, it is sometimes criticized as OECD Club-rule. McDonough (2000) argues that as banks have developed innovative techniques for managing and mitigating risk, credit risk now exists in more complicated, less conventional forms than is recognized by the 1988 Accord, thus rendering capital ratios, as presently calculated, less useful to banking supervisors. The financial world has changed dramatically over the past dozen years, to the point that the Accord efficacy has eroded considerably (McDonough, 2000).
Development of Basel II Accord:
The Basel Committee on Banking Supervision has been working over recent years to secure international convergence on revisions to supervisory regulations governing the capital adequacy of internationally active banks in order to rectify the weaknesses of Basel I accord. Following the publication of the Committee’s first round of proposals for revising the capital adequacy framework in June 1999, an extensive consultative process was set in motion in all member countries and the proposals were also circulated to supervisory authorities worldwide. The Committee subsequently released additional proposals for consultation in January 2001 and April 2003 and furthermore conducted three quantitative impact studies related to its proposals. As a result of these efforts, many valuable improvements have been made to the original proposals. The final Basel II accord presents the consensus agreed by all its members. It sets out the details of the agreed Framework for measuring capital adequacy and the minimum standard to be achieved which the national supervisory authorities represented on the Committee will propose for adoption in their respective countries. This Framework and the standard it contains have been endorsed by the Central Bank Governors and Heads of Banking Supervision of the Group of Ten countries.
The primary objective of the new Accord is to make it more risk-sensitive so that financial institutions will be able to sustain even in periods of financial crisis. Consequently, the new proposal moves ahead of the “one-size-fit-all” approach. Another objective of the Accord is to continue to enhance competitive equality among the internationally active banks throughout the world.
The Committee believes that the revised Framework will promote the adoption of stronger risk management practices by the banking industry, and views this as one of its major benefits. The Committee notes that, in their comments on the proposals, banks and other interested parties have welcomed the concept and rationale of the three pillars (minimum capital requirements, supervisory review, and market discipline) approach on which the revised Framework is based. More generally, they have expressed support for improving capital regulation to take into account changes in banking and risk management practices while at the same time preserving the benefits of a framework that can be applied as uniformly as possible at the national level.
In developing the revised Framework, the Committee has sought to arrive at significantly more risk-sensitive capital requirements that are conceptually sound and at the same time pay due regard to particular features of the present supervisory and accounting systems in individual member countries. The Committee is also retaining key elements of the 1988 capital adequacy framework, including the general requirement for banks to hold total capital equivalent to at least 8% of their risk-weighted assets; the basic structure of the 1996 Market Risk Amendment regarding the treatment of market risk; and the definition of eligible capital.
A significant innovation of the revised Framework is the greater use of assessments of risk provided by banks’ internal systems as inputs to capital calculations. In taking this step, the Committee has also put forward a detailed set of minimum requirements designed to ensure the integrity of these internal risk assessments. Each supervisor will develop a set of review procedures for ensuring that banks’ systems and controls are adequate to serve as the basis for the capital calculations. Supervisors will need to exercise sound judgments when determining a bank’s state of readiness, particularly during the implementation process.
The revised Framework provides a range of options for determining the capital requirements for credit risk and operational risk to allow banks and supervisors to select approaches that are most appropriate for their operations and their financial market infrastructure. In addition, the Framework also allows for a limited degree of national discretion in the way in which each of these options may be applied, to adapt the standards to different conditions of national markets. These features, however, will necessitate substantial efforts by national authorities to ensure sufficient consistency in application. The Committee intends to monitor and review the application of the Framework in the period ahead with a view to achieving even greater consistency. In particular, its Accord Implementation Group (AIG) was established to promote consistency in the Framework’s application by encouraging supervisors to exchange information on implementation approaches.
It should be stressed that the revised Framework is designed to establish minimum levels of capital for internationally active banks. As under the 1988 Accord, national authorities will be free to adopt arrangements that set higher levels of minimum capital. Moreover, they are free to put in place supplementary measures of capital adequacy for the banking organizations they charter. National authorities may use a supplementary capital measure as a way to address, for example, the potential uncertainties in the accuracy of the measure of risk exposures inherent in any capital rule or to constrain the extent to which an organization may fund itself with debt. Where a jurisdiction employs a supplementary capital measure (such as a leverage ratio or a large exposure limit) in conjunction with the measure set forth in this Framework, in some instances the capital required under the supplementary measure may be more binding. More generally, under the second pillar, supervisors should expect banks to operate above minimum regulatory capital levels.
Under the Basel II accord, banks and supervisors are to give appropriate attention to the second (supervisory review) and third (market discipline) pillars of the revised Framework. It is critical that the minimum capital requirements of the first pillar be accompanied by a robust implementation of the second, including efforts by banks to assess their capital adequacy and by supervisors to review such assessments. In addition, the disclosures provided under the third pillar of this Framework will be essential in ensuring that market discipline is an effective complement to the other two pillars.
The Committee is aware that interactions between regulatory and accounting approaches at both the national and international level can have significant consequences for the comparability of the resulting measures of capital adequacy and for the costs associated with the implementation of these approaches. The Committee believes that its decisions with respect to unexpected and expected losses represent a major step forward in this regard.
The Committee has designed the revised Framework to be a more forward-looking approach to capital adequacy supervision, one that has the capacity to evolve with time. This evolution is necessary to ensure that the Framework keeps pace with market developments and advances in risk management practices, and the Committee intends to monitor these developments and to make revisions when necessary. In this regard, the Committee has benefited greatly from its frequent interactions with industry participants and looks forward to enhanced opportunities for dialogue. The Committee also intends to keep the industry appraised of its future work agenda.
Scope of Application
This Framework will be applied on a consolidated basis to internationally active banks. This is the best means to preserve the integrity of capital in banks with subsidiaries by eliminating double gearing.
The scope of application of the Framework will include, on a fully consolidated basis, any holding company that is the parent entity within a banking group to ensure that it captures the risk of the whole banking group. Banking groups are groups that engage predominantly in banking activities and, in some countries, a banking group may be registered as a bank.
The Framework will also apply to all internationally active banks at every tier within a banking group, also on a fully consolidated basis (see illustrative chart at the end of this section). A three-year transitional period for applying full sub-consolidation will be provided for those countries where this is not currently a requirement.
Further, as one of the principal objectives of supervision is the protection of depositors, it is essential to ensure that capital recognized in capital adequacy measures is readily available for those depositors. Accordingly, supervisors should test that individual banks are adequately capitalized on a stand-alone basis.
Banking, securities and other financial subsidiaries
To the greatest extent possible, all banking and other relevant financial activities (both regulated and unregulated) conducted within a group containing an internationally active bank will be captured through consolidation. Thus, majority-owned or –controlled banking entities, securities entities (where subject to broadly similar regulation or where securities activities are deemed banking activities) and other financial entities should generally be fully consolidated.
There may be instances where it is not feasible or desirable to consolidate certain securities or other regulated financial entities. This would be only in cases where such holdings are acquired through debt previously contracted and held on a temporary basis, are subject to different regulation, or where non-consolidation for regulatory capital purposes is otherwise required by law. In such cases, it is imperative for the bank supervisor to obtain sufficient information from supervisors responsible for such entities.
If any majority-owned securities and other financial subsidiaries are not consolidated for capital purposes, all equity and other regulatory capital investments in those entities attributable to the group will be deducted, and the assets and liabilities, as well as third-party capital investments in the subsidiary will be removed from the bank’s balance sheet. Supervisors will ensure that the entity that is not consolidated and for which the capital investment is deducted meets regulatory capital requirements. Supervisors will monitor actions taken by the subsidiary to correct any capital shortfall and, if it is not corrected in a timely manner, the shortfall will also be deducted from the parent bank’s capital.
Significant minority investments in banking, securities and other Financial entities
Significant minority investments in banking, securities and other financial entities, where control does not exist, will be excluded from the banking group’s capital by deduction of the equity and other regulatory investments. Alternatively, such investments might be, under certain conditions, consolidated on a pro rata basis. For example, pro rata consolidation may be appropriate for joint ventures or where the supervisor is satisfied that the parent is legally or de facto expected to support the entity on a proportionate basis only and the other significant shareholders have the means and the willingness to proportionately support it. The threshold above which minority investments will be deemed significant and be thus either deducted or consolidated on a pro-rata basis is to be determined by national accounting and/or regulatory practices. As an example, the threshold for pro-rata inclusion in the European Union is defined as equity interests of between 20% and 50%.
The Committee reaffirms the view set out in the 1988 Accord that reciprocal crossholdings of bank capital artificially designed to inflate the capital position of banks will be deducted for capital adequacy purposes.
A bank that owns an insurance subsidiary bears the full entrepreneurial risks of the subsidiary and should recognize on a group-wide basis the risks included in the whole group. When measuring regulatory capital for banks, the Committee believes that at this stage it is, in principle, appropriate to deduct banks’ equity and other regulatory capital investments in insurance subsidiaries and also significant minority investments in insurance entities. Under this approach the bank would remove from its balance sheet assets and liabilities, as well as third party capital investments in an insurance subsidiary. Alternative approaches that can be applied should, in any case, include a group-wide perspective for determining capital adequacy and avoid double counting of capital.
Banks should disclose the national regulatory approach used with respect to insurance entities in determining their reported capital positions.
Significant investments in commercial entities
Significant minority and majority investments in commercial entities which exceed certain materiality levels will be deducted from banks’ capital. Materiality levels will be determined by national accounting and/or regulatory practices. Materiality levels of 15% of the bank’s capital for individual significant investments in commercial entities and 60% of the bank’s capital for the aggregate of such investments, or stricter levels, will be applied. The amount to be deducted will be that portion of the investment that exceeds the materiality level.
Investments in significant minority- and majority-owned and -controlled commercial entities below the materiality levels noted above will be risk-weighted at no lower than 100% for banks using the Standardized approach. For banks using the IRB approach, the investment would be risk weighted in accordance with the methodology the Committee is developing for equities and would not be less than 100%.
Deduction of investments pursuant to this part
Where deductions of investments are made pursuant to this part on scope of application, the deductions will be 50% from Tier 1 and 50% from Tier 2 capital.
Goodwill relating to entities subject to a deduction approach pursuant to this part should be deducted from Tier 1 in the same manner as goodwill relating to consolidated subsidiaries, and the remainder of the investments should be deducted as provided for in this part. A similar treatment of goodwill should be applied, if using an alternative group-wide approach pursuant to paragraph 30.
The limits on Tier 2 and Tier 3 capital and on innovative Tier 1 instruments will be based on the amount of Tier 1 capital after deduction of goodwill but before the deductions of investments pursuant to this part on scope of application.
Analysis of Credit Risk Approaches of Basel II
Reports and articles published in various financial magazines reveal that most bank supervisors across the globe will implement Basel II as a key part of their bank supervisory regime, and that in most countries the larger banks are generally aiming to go beyond the Standardized approach to use one of the Internal Ratings Based (IRB) approaches to credit risk. The IRB approaches are likely to be adopted in the more developed banking systems (Japan, Hong Kong, Singapore) starting around 2007 to 2008 and in others in subsequent years. While over time the adoption of the IRB approaches should lead to more sophisticated risk management practices, developing the risk rating systems and infrastructure needed to become an IRB bank could pose challenges for a number of Asian institutions, most of which are in the early stages of building up their loss databases, developing ratings models and improving the integrity of their risk management systems.
Implementing Basel II and supervising IRB banks will present challenges for bank supervisors as well, as more technical skills and resources will be needed. Countries that are planning to adopt Basel II have to think carefully about these resource needs and consider the benefits and costs of Basel II adoption within the broader context of their other supervisory priorities. For example, strengthening the fundamentals of their legal and regulatory infrastructure is likely a more immediate priority than – and indeed an important precursor to – moving to introduce Basel II. If their Basel II implementation efforts are to be credible, supervisors will need to move away from the past tendency (prevalent in many countries) to use regulatory forbearance to support weak banks. In terms of the potential market impact of Basel II, the effects are likely to vary across banks depending on their choice of regulatory approach (i.e., Standardized, Foundation IRB, Advanced IRB) as well as the composition of their portfolios. As a general matter, weaker borrowers will attract higher charges under Basel II, which may raise their borrowing costs. Stronger borrowers are likely to benefit from lower capital charges under a Basel II capital regime Retail lending also becomes even more attractive under Basel II thanks to the generally lower charges assigned to residential mortgage and credit card lending, which may accelerate the existing shift of Asian banks toward retail banking.
An important consideration facing supervisors is how well suited the Basel II framework is to their market and whether the Basel II charges are sufficient to cover banks’ risk exposure. In cases where the supervisor believes that Basel II does not fully capture inherent risks in the domestic banking system, then it is appropriate for them to apply “super-equivalent” (i.e., more stringent) charges. For example, the recent problematic experience of some areas of retail lending, such as credit cards in Korea, might suggest that additional capital is needed to cover the risks of this market. As an additional example, under the Foundation IRB the assumed loss rate when a loan defaults (LGD) is 45% for unsecured corporate loans (i.e., a recovery rate of 55%); however, in reality, loss rates on unsecured lending in emerging Asia have been much higher than this level.
Bank supervisors will need to consider carefully whether the assumptions built in to Basel II are applicable to their banking systems. If in their view the charges do not fully capture the risks inherent in local markets, supervisors could either decide to apply more conservative assumptions within the capital calibration for specific assets (such as applying a higher risk-weight than Basel II), or set overall capital requirements at a higher level than 8%. More broadly, this highlights the need for national supervisors not simply to import the Basel Committee guidelines wholesale, but to adapt them to local realities.
Basel II is built on the so-called “Three Pillars” of capital adequacy, namely:
- Pillar 1: the Minimum Capital Requirement
- Pillar 2: Supervisory Oversight
- Pillar 3: Market Discipline, based on risk-based disclosure.
Most attention is focused on Pillar 1, as the new approaches to measuring capital requirements, particularly those based on internal bank risk estimates, are the most cutting edge, and arguably the most technically complex, part of the new accord. However, the Basel Committee has been keen to emphasize that Basel II will not work effectively if the other two pillars are not properly implemented.
The role of supervisors, captured under Pillar 2, remains important under Basel II. Arguably it assumes an even greater importance, as they will need the technical expertise and judgment to review and monitor the risk rating, risk measurement, and capital allocation practices of banks, as well as to conduct appropriate supervision of the risks not covered directly in the Basel II capital charges (an example being interest rate risk). Pillar 3 is also extremely important and potentially has big implications for banks as the types of risk disclosure required go far beyond the information made publicly available by most banks today.
Pillar 1: The Minimum Capital Requirement
Banks are required to have sufficient capital to cover credit, market and operational risk, the latter being a new element of regulatory ratios, as Basel I had no explicit capital charge for operational risk.
The New Basel II Credit Risk Measures
To address the shortcomings of Basel I, one fundamental innovation under Basel II is the use of credit ratings to provide a more refined measure of a bank’s credit risk exposure.
The Standardized approach to credit risk is designed for banks with less complex operations and activities. For corporate and securitized assets, it allows banks to calculate capital charges based on broad groupings of the external ratings of the claim assigned by a recognized credit rating agency (an “External Credit Assessment Institution” or “ECAI” in Basel parlance).
The IRB approach, intended for banks with more sophisticated risk measurement and management systems, allows banks to determine their capital charges based on internal estimates of risk. While the IRB approach is, at heart, a credit risk model, it has been designed and parameterized by regulators to promote safety and soundness within the banking system. Thus, while some observers talk of “regulatory capture” (whereby regulators have, so the argument goes, given up some of their powers and, in effect, allowed banks to influence the regulatory process by determining their own capital requirement), the reality is that the Basel Committee has devoted much effort to devising formulas and developing stringent operational requirements that help to ensure that its prudential objectives for safety and soundness are satisfied. It is certainly true that banks will have a greater role in determining their capital requirement, but this reflects the fact that the IRB approach is an attempt to bring regulatory capital, i.e. that required by the regulators, more closely into line with economic capital, i.e. the level determined by the banks as needed to cover the various risks to which their businesses expose them.
The objective of the Basel Committee has been to produce capital standards that would not reduce the amount of capital held by banks in aggregate but would align capital requirements more closely with underlying risk – such that banks with lower risk exposure would have to hold less capital than those with higher risks. By providing banks with the option to use more refined risk measures based on internal estimates, Basel II also aims to give an incentive to banks to develop more sophisticated risk management systems. Hence, the impact on overall capital requirements, after factoring in the introduction of the explicit new charge to capture operational risks, is likely to be at best neutral under the Standardized Approach and could be modestly positive (i.e. requiring less capital) under the more advanced Basel II measurement approaches. These trends are broadly reflected in the results of the quantitative impact testing that the Basel Committee has performed on a range of banks globally.
As is well known, there are three approaches (The Standardized, the Foundation IRB, and the Advanced IRB) that banks can choose to follow to calculate their minimum capital requirements for credit risk.
The Standardized Approach
This simple approach represents only a limited departure from Basel I. The main changes are the move away from the flat 8% capital charge for corporate risks to a system with slightly more differentiation of risk, and the move away from using OECD membership as the key criterion for assigning capital charges to banks and sovereigns to a system making greater use of external credit ratings to differentiate credit risk. More specifically, Basel II groups different external ratings into broad categories or “buckets”, with claims in the higher rated buckets generally benefiting from lower charges than those in the lower-rated buckets. For claims on banks, one option (Option 1) sets charges based on the sovereign rating (generally the charge is one notch higher than the underlying sovereign charge) while Option 2 bases the charge on the external rating assigned to the bank itself.
Ratings are also used for evaluating corporate borrowers as well. To help tackle the regulatory “arbitrage” strategies under Basel I, Basel II recognizes the higher risk of subordinated securization positions by assigning more punitive charges to lower rated tranches than an unsecuritised asset with a comparable credit rating. Retail lending generally attracts a more favorable treatment than under Basel I. Another important change under Basel II is that off-balance sheet commitments less than one-year attract a higher conversion factor and, in turn, a higher capital charge than Basel I (which applied a 0% conversion factor to short-term commitments).
Before allowing ECAIs such as the rating agencies, national supervisor will have to ensure that they fulfill the following standards set by Basel Committee (2004):
(i) Objectivity: The methodology for assigning credit assessments must be rigorous, systematic and subject to some form of validation based on historical experience. Before being recognized by supervisors, an assessment methodology for each market segment, including rigorous back testing, must have been established for at least one year and preferably three years.
(ii) Independence: An ECAI should be independent and should not be subject to political or economic pressures that may influence the rating. The assessment process should be as free as possible from any constraints that could arise in situations where the composition of the board of directors or the shareholder structure of the assessment institution may be seen as creating a conflict of interest.
(iii) International access/Transparency: The individual assessments should be available to both domestic and foreign institutions with legitimate interests and at equal terms. In addition, the general methodology used by the ECAI should be publicly available.
(iv) Disclosure: An ECAI should disclose the information on its assessment methodologies, including the definition of default, the time horizon and the meaning of each rating, the actual default rates experienced in each assessment category, and the transitions of the assessments i.e., the likelihood of AA ratings becoming A over time.
(v) Resources : An ECAI should have sufficient resources to carry out high quality credit assessments. These resources should allow for substantial ongoing contact with senior and operational levels within the entities assessed in order to add value to the credit assessments.
In addition, supervisors will be responsible for assigning eligible ECAIs’ assessments to the risk weights available under the standardized risk weighting framework, i.e., deciding which assessment categories correspond to which risk weights.
Impact of Basel II credit risk charges
Having provided an overview of the options under Basel II for measuring credit risk (i.e., Standardized, Foundation IRB, Advanced IRB), we turn now to how these approaches might affect the capital charges on various types of activities and assets, including retail lending, commercial real estate lending, collateralized lending, exposures hedged by guarantees and credit derivatives, and equity investments.
Under the Standardized approach the capital charge for retail assets will decrease significantly, with the charge for residential mortgages reduced from 4% (50% risk weight) to 2.8% (35% risk weight) and other types of retail exposures (i.e. small scale and highly diversified lending to individuals and small businesses) qualifying for a 6% charge (75% risk weight). The criteria for small business loans to qualify for retail (as opposed to corporate) treatment are that they should be revolving facilities in a diversified portfolio with a maximum size of EUR1m.
An important element of the Basel II retail treatment is the capital charge for the unused portion of credit lines, which could materially affect credit card lenders given that such unused lines generally qualified for a 0% credit conversion factor and hence a 0% capital charge under Basel I.
For retail exposures there is no distinction between Foundation and Advanced IRB. All IRB banks will be expected to calculate the PD, LGD and EAD on its retail portfolios. There is no explicit maturity adjustment, as the differences in tenor of retail assets is reflected in part in the differing correlation values (e.g. residential mortgages are subject to a higher correlation assumption than other types of retail lending).
The IRB retail portfolio is sub-divided into the following categories:
Credit cards, which include not only drawn exposures, but also undrawn lines.
Residential mortgages, which is geared to owner-occupied residential property, however regulators are permitted some flexibility in extending it to rental properties in buildings containing only a small number of rental units.
“Other” retail lending, which includes lending such as auto loans, student loans and small business loans (under EUR1m).
Type of Lending Correlation Factor (%)
Residential Mortgages 15
Credit Cards* 4
Other Retail Loans A Range of 16% to 3% depending on the PD of the Borrower
* And other qualifying revolving retail exposures.
Source: Fitch, Basel Committee.
An important difference between the Standardized and IRB approaches to retail lending is that, while Standardized banks apply fixed charges irrespective of borrower quality, the IRB charges will vary as a function of the borrower’s risk profile. For example, as shown in the chart, the curve for residential mortgages produces a capital charge of 2.8%, equal to the Standardized approach charge, when the PD is just under 3% and assuming an LGD of 15% (which seems generally consistent with typical recovery rates on this type of lending). Thus, Standardized banks will face lower charges than IRB banks on riskier borrowers (i.e., those with higher PDs and LGDs) – and likewise will face higher charges than IRB banks on higher quality borrowers. This means that Standardized banks will have an incentive to take on lower quality mortgage borrowers, while IRB banks have an incentive to focus on better quality (i.e., low PD, low LGD) borrowers.
Commercial Real Estate Lending
Commercial real estate (“CRE”) lending generally receives an 8% charge under the Standardized approach, although certain forms of CRE mortgage lending are eligible for a 4% charge.
For IRB banks, Basel II differentiates between two different types of CRE lending:
- “IPRE” or Income Producing Real Estate, i.e. more stable real estate lending with more predictable loss patterns.
- “HVCRE” High Volatility Commercial Real Estate, i.e. lending with less predictable patterns, such as acquisition, development and construction lending. HVCRE is deemed to be higher risk than IPRE and is thus subject to higher capital charges (which in practice is achieved through higher correlation values at the higher quality or low PD end of the credit spectrum).
Loan Loss Provisions under Basel II
The implementation of Basel II will likely affect the way banks provision for credit losses, particularly under the IRB approach. In this regard, it will be interesting to see how Basel II will interact with the complex interplay of accounting and other regulatory considerations that factor into bank reserving practices.
The treatment of provisions does not change much under the Standardized approach. There is some room for banks to obtain a lower charge on past due assets if certain provisioning thresholds are met (e.g., Standardized banks can apply an 8% charge instead of a 12% charge against past due loan if provisions exceed 20% of outstanding amount).
Under the IRB approach, banks will be expected to set up sufficient loan loss reserves to cover their EL exposure, while the minimum capital charges are designed to cover the bank’s UL exposure. As noted, EL represents the mean or average loss a bank can reasonably expect to incur on an asset. Thus, addressing EL through a bank’s reserves should have a positive impact on linking provisioning practices to a quantitative, rigorous estimate of economic loss.
Under the IRB approach, any shortfall in reserves, below the level of EL, is to be deducted from the banks’ capital (equally from Tier 1 and Tier 2 capital). Any excess reserves over and above the amount of EL can be added to capital, but only to Tier 2 capital and subject to a limit of 0.6% of RWA. This treatment appears to be a disincentive for banks to either under- or over-provide, suggesting that the Basel Committee wanted to set incentives for banks to reserve in line with, but not much beyond, their EL exposure.
Potential problems could arise to the extent that Basel II and IFRS provide differing guidance on the level of reserves a bank is expected to establish. Put simply, Basel II’s concept of EL, devised by regulators concerned about bank soundness, is a statistically-based forecast of the economic loss that can be reasonably expected to occur. This might result in a differing level of provisions than would be established under IFRS, which are limited to “objective impairment” (IAS 39) either individually or collectively for a group of loans/assets with similar risk characteristics.
An additional complicating factor is that national regulators may lay down their own country-specific loan loss reserve requirements, including the maintenance of general loan loss reserves at a level that may exceed reserves allowed under IFRS. The importance of tax rules cannot be overlooked since they are often a factor influencing bank’s provisioning levels, although it will likely be more difficult under IFRS to make tax-driven loan loss provisions.
It is not yet clear how these factors will interact and whether (and to what extent) accounting loan loss reserves under IFRS will differ from a regulatory EL-based approach to reserving under Basel II. More significantly, accounting and regulatory capital will increasingly diverge in other areas. A notable feature of IFRS, similarly to US GAAP, is the much narrower definition of “equity” vis-à-vis “debt”, excluding not only hybrid capital instruments that have been allowed in limited amounts as Tier 1 capital by regulators, but also many preferred shares, which, because of their obligation to pay a “fixed” return, are deemed to have debt-like characteristics.
Equity (Investments) in the Banking Book
The treatment of equity investments was one of the weaknesses of Basel I since it is clear that an 8% capital charge for equities – the same as for high quality corporate debt – is generally not sufficient to cover the risk, particularly given that equity serves as a first loss position and is more subordinated in the firm’s capital than debt. IRB banks can use one of two possible approaches to assessing charges against equity investments.
One option is the market-based approach, allowing IRB banks to use an internal VAR model subject to certain floors (minimum capital charge of 16% for publicly quoted stocks and 24% for private). Banks unable to model the risk would apply fixed-risk weights to the equity exposure (e.g. 24% capital charge on publicly-traded equities). The other option is a “PD/LGD” approach based on the Foundation IRB for corporates, i.e. the bank estimates the default risk and then applies a 90% LGD and five-year maturity
Qualifying for IRB: What Banks Need to do
Banks wishing to qualify for IRB are required to meet certain standards concerning their rating system and process, their risk measurement, as well as the oversight and governance of their ratings system. The aim is to provide supervisors with comfort that banks are able to assess, differentiate and quantify their credit risk exposure in a consistent and credible manner. The standards appear broadly consistent with the “best practices” of the banking industry.
Much of the formal responsibility for reviewing and monitoring banks’ abilities to meet these standards lies in the hand of national regulators. However, it is also important for banks to communicate to the market information about their ratings processes and risk measurement techniques, including their use of historical loss data.
The Rating System
A bank’s rating system is expected to differentiate risk of different borrowers in a meaningful way. As evidence of this, a bank’s rating scale must not only have a sufficient number of rating categories (the IRB minimum is seven grades for performing assets), but credits must be distributed across the different categories (i.e. a preponderance of loans in the same category would suggest an ineffective system).
Importantly, ratings must be clearly defined and based on meaningful criteria. In short, the ratings must provide both an ordinal (a ‘BBB’ credit must be better than a ‘B’ etc); and cardinal measure of risk (e.g. a ‘BBB’ is associated with a specific PD value).
A critical factor in understanding a bank’s measure of credit risk under Basel II is its internal ratings philosophy and the horizon of its ratings assessments. Some banks choose to rate by taking into consideration possible stresses through the business cycle (a “through-the-cycle” approach). Other banks use more of a “point-in-time” approach, reflecting the impact of fluctuations in the business cycle through frequent and aggressive rating changes. The bank’s rating philosophy will therefore influence the volatility of ratings, the distribution of credits across different rating categories, and the default rates associated with each category.
Basel II appears to give banks the flexibility to follow either type of ratings approach. On one hand, IRB banks are expected to forecast their default risk over a one-year horizon, which would capture only a portion of the cycle and thus suggest a point-in-time perspective. However, banks are required to use longer-run averages of annual default rates when estimating PD (at least 5 years) and are expected to use a “longer time horizon” in assigning ratings, which would indicate more of a through-the-cycle approach. In evaluating capital adequacy, supervisors will need to understand the nuances of each bank’s ratings approach and risk assessment horizon, particularly in light of the generally more volatile, cyclical performance of financial markets.
Use of Historical Loss Data
To understand a bank’s internal risk-rating system and credit risk measurement approach, the bank’s use of historical data to derive loss estimates for each rating grade needs to be assessed. IRB banks will need to have a minimum of five years of data to measure PD and seven years of data for LGD (five years of LGD data are needed for retail assets).
However, these are minimum standards and banks will need to carefully assess whether the data history they use is both sufficient to address risks across the market cycle and whether it is a relevant benchmark for the bank’s own actual portfolio.
Data is also critical in how banks validate their loss estimates. One aspect of validation is to analyze the bank’s predicted estimates against the actual realized experience. However, differences between the two do not necessarily mean the bank’s risk ratings are not functioning properly. For example, in periods of extreme market volatility, more recent loss experience will likely exceed the longer-run historical averages used to help generate the bank’s PD and LGD estimates. Thus, validation should extend beyond such data comparisons and more broadly address the bank’s processes for estimating risk.
Oversight and Governance
IRB banks are expected to have a strong system of controls to promote the integrity of their ratings and avoid potential conflicts of interest in the ratings process. Specifically, the Board and senior management must have a good understanding of the rating system and be able to make informed decisions on any material changes in risk management practices. Basel II also advocates that banks have an independent control unit that monitors the ratings process.
A broader component of corporate governance is that bank’s meet the so-called “use test” – that is, the risk ratings process should serve as an integral part of the bank’s business activities (e.g., pricing), daily operations, and strategic planning, and not just a regulatory compliance tool. The “use test” thus helps promote the broader dissemination of a risk-focused culture and decision-making process.
New Capital Charge for Operational Risk
In addition to the more refined measurement of credit risk, a key innovation of Basel II is the introduction of an explicit capital charge for operational risk. Basel II defines operational risk as “the risk of loss resulting from inadequate or failed internal processes, people and systems”. It includes legal risk but excludes reputation risks and indirect losses, which are difficult to quantify but should still be addressed within a bank’s risk management strategy.
There are three approaches to calculating a capital charge for operational risk.
- The Basic Indicator Approach, which sets the capital charge at 15% of the average annual gross income for the previous three years. (Gross income excludes any provisions and exceptional items, insurance income and any sales/losses in the banking book.)
- The Standardized Approach under which annual gross income is broken down by business line and different weights are assigned:
Business Line (%)
Corporate Finance 18
Trading & Sales 18
Retail Banking 12
Commercial Banking 15
Payment & Settlement 18
Agency Services 15
Asset Management 12
Retail Brokerage 12
Source: Fitch, Basel Committee
- Advanced Measurement Approaches (“AMA”). Under the AMA the capital requirement is based on the amount of operational risk exposure calculated by the bank’s internal system, which must meet data and measurement criteria prescribed under Basel II and is subject to regulatory approval.
Fitness of the various credit risk measurement approaches for Bangladesh
It is argued that in many countries, low rating penetration and a lack of domestic rating agencies may pose a challenge for implementation of the standardized approach, particularly in respect of corporate claims. This is not untrue for Bangladesh where the rating industry is not advanced enough and the majority of the individual claims of bank loans remain unrated. Currently two rating agencies, namely CRISL and CRAB, are operative in the financial market. If the standardized approach is adopted, it is highly likely that regulation may force the banks to rush to them. Since banks in Bangladesh are linked with tens of thousands of borrowers, the capability of these two rating agencies in terms of credit assessment of those borrowers within the regulatory timeframe may not be sufficient. Adopting SA without having sufficient number and depth of rating agencies may also cause other problems. For example, cost of credit assessment may be substantially increased due to high regulatory demand for this service. This, in turn, may increase lending price and may affect banks’ profitability.
The Accord requires that the assessment process should be as free as possible from any constraints that could arise in situations where the composition of the board of directors or the shareholder structure of the assessment institution may be seen as creating a conflict of interest. However, the existing Credit Companies Rules that was enacted in 1996 to regulate the business of credit rating agencies has not considered this issue in line with Basel’s new standard. It is understood that directors of the existing rating agencies are directors of the scheduled banks as well as directors of other public and private companies. This type of conflict of interest may cause for rating-biases and need to be addressed urgently through legal changes before adopting the standardized approach. High default culture in the financial market of Bangladesh indicates that existing weak regulatory framework for rating agencies may influence borrowers’ behavior to obtain good rating inappropriately. Therefore rating regulations need to be updated to address such potential problems. A conference (Effects of Implementing Basel II in Emerging Markets) was held in Panama on 13 April 2004 where it was concluded that the “Full” Standardized Approach cannot function properly without an adequate regulatory framework for credit rating agencies. On the other hand, it expressed concern on the role of credit rating agencies for two major reasons: (i) the track record of these agencies in their region in assessing risks was not satisfactory and (ii) the use of credit rating for the purpose of determining required capital might result in biased ratings of borrowers.
It can be noted that credit risk modeling, back-testing and forecasting require high level knowledge of probability statistics, financial econometrics and times series analysis. It is yet to be ascertained whether the existing rating agencies have sufficient qualified human resources who can perform those activities in a professionally competent manner. Since rating greatly depends on long historical data, given that the industry is of recent origin, it can be assumed that they may not have sufficient database to validate their models.
To make a choice between the two IRB Approaches, their appropriateness in the existing market conditions need to be assessed. Both of these approaches, in fact, require risk modeling by the banks themselves. Since risk modeling is a new concept for the banking sector of Bangladesh, it can therefore be assumed that banks do not have adequate trained human resources in this regard. Between these two approaches, Advanced Approach is more sophisticated than the Foundation Approach. Adoption of the Advanced Approach requires the banks to have some years of practical experience in exercising risk modeling and forecasting. Accuracy of these models in calculating risk needs to be examined and validated. In this matter, another important point needs to be considered. Advanced Approach will allow the banks to determine LGD and EAD independently. Since these two variables are inputs in the calculation of minimum capital requirement for credit risk, manipulation of these two variables by the banks may significantly change their capital requirement. Considering the above factors, it can be argued that the Foundation Approach seems to be more appropriate than the Advanced Approach in the banking sector of Bangladesh.
Since other countries, like Bangladesh, will face some common challenges, it would be better to look into the examples of other nations. A survey conducted by Financial Stability Institute (FSI, 2004) has indicated that globally more than 100 countries are going to implement new Basel Accord. However, in measuring credit risk and calculating minimum capital requirement against it, the highest percentage of banking asset will be subject to IRB Foundation Approach followed by Standardized/ Simplified Standardized Approach
Final Decision by Bangladesh Bank:
Due to the advantages and disadvantages of the various approaches, the steering committee of Bangladesh Bank on Basel II Accord finally decided in NOV06 to adopt the following road map for implementation of Basel II in Bangladesh after seven months of spadework. The decisions were based on various factors like the existing structure of the banking industry, presence of required infrastructure, human resource development and technological capacity, time period remaining for Basel II implementation etc.
|Credit Risk||Basel I will continue in effect until 31DEC08. Migration to Basel II under the Standardized Approach from 01JAN09.|
|Market Risk||With effect from 01JAN09, under the Standardized Approach|
|Operational Risk||With effect from 01JAN09, under the Basic Indicator Approach|
Bangladesh Bank noted in the meeting that based on the current scenario, it might take several years for Bangladesh to move in to the Advanced Approaches.
The Central bank in a recent circular also made it mandatory for all banks to have themselves rated by a credit rating agency (CRA) effective from January 2007. Bangladesh Bank will also go for a quantitative impact study to assess the possible impacts of the implementation of the Basel II accord in the country’s banking sector, sources said.
Two high-powered committees are now working for formulating policy and supervising the Basel II implementation process. The central bank deputy governor, Muhammad A (Rumee) Ali, heads the nine-member steering committee while the executive director, Asaduzzaman Khan, chairs the 21-member coordination committee.
Implications for HSBC Bangladesh of Basel II implementation
As discussed earlier, the Basel II Framework will also apply to all internationally active banks at every tier within a banking group, also on a fully consolidated basis. This means that subsidiaries or country offices of an internationally active bank operating in a certain jurisdiction will have to meet the capital adequacy requirement set out by the local regulator, while the holding company of the bank or the group will also have to meet the capital adequacy requirement on a consolidated basis in its country of incorporation.
HSBC being an internationally active bank and having its registered office in UK, the implication for HSBC Bangladesh is that it will have to follow the credit risk approach set by Bangladesh Bank on a local level, while at the same time following the credit risk approach set by the group. As it happens to be, HSBC Group, on the whole, has decided to follow the IRB – Advanced Approach, which is more advanced than the Standardized Approach prescribed by Bangladesh Bank.
In order to benefit its’ global business, HSBC’s strategy is to progress wherever feasible towards IRB-Advanced approach to cover all of core credit risk exposures. The FSA has already endorsed HSBC’s plan to adopt the IRB Advanced approach for Credit Risk with effect from 1st January, 2008 on the basis of a roll out plan that will achieve 85% coverage by 2010.
The impact of this is that:
- Parallel running for FSA (and FRB) purposes will start on 1st January 2007.
- Public disclosure will commence during 2008 with Basel II RWAs calculated on a basis of a combination of Standardised, IRB-F and IRB-A as appropriate.
- HSBC UK (HBEU) and HSBC USA & Canada (HNAH) and HSBC Mexico (HBMX) has commenced a two-year experience requirement for IRB Advanced Approach (IRBA) starting on 1st January 2006 to enable those entities to be treated as IRB effective 1st January 2008.
- HSBC Asia Pacfic (HBAP), of which HSBC Bangladesh is a subsidiary, will commence reporting IRBA on 1st January 2009, HSBC France (HBFR) & HSBC Germany (HTDE) on 1st January 2010.
Changes Already Introduced in Credit Evaluation Processes
In order to prepare for the adoption of the IRB Advanced Approach, some groupwide changes have already been introduced in HSBC.
- HSBC in the past has been very thorough in maintaining essential default information set. This has allowed HSBC to develop a rating system that can be used for determining each borrower’s credit quality or, in other words, its probability of default. This is known as Customer Risk Rating (CRR) Scale (discussed earlier). The CRR, which is a two dimensional methodology that separately assesses the risk of borrower Probability of Default (PD) and the risk of likely loss in the event of default, is replacing the judgmental Facility Grade (FG) 1-7 approach that was used earlier to rate a client.
- The credit evaluation process is clearly segregating the components of a risk profile assessment i.e. Probability of Default (PD), Loss Given Default (LGD) and Exposure at Default (EaD) to quantify transaction risk.
- Introduction and use of an internal ratings based scorecards (called Moody’s Financial Analyst) is being used to derive PD% (Probability of Default) that is being used on the 22 point logarithmic Customer Risk Rating Scale (CRR)
- Policies and procedures have been published to cover parental support and adjusting (“overriding”) the CRR proposed by the models / scorecards.
- LGD (Loss Given Default) is being calculated based on parameters for collateral based upon differing recovery rates and seniority of unsecured exposures.
- EaD is being calculated based on total limit sanctioned to a customer, with the conservative view that the client may fully draw down its facilities.
- The credit application process will be standardised using the CARM system and will contain the CRR and information on estimated LGD% and EaD. Credit applications will continue to contain both the FG and CRR (and LGD) of the client during a transition phase.
- The credit application process has been standardised using the CARM system and contains the CRR and information on estimated LGD% and EaD. Credit applications will continue to contain both the FG and CRR (and LGD) of the client during a transition phase.
The main impacts will be
- The IRBA will allow HSBC to follow risk-based pricing strategy, whereby exposure to less risky clients will command lower capital charge, resulting in lower pricing for the less risky customers.
- Beneficiaries of this risk-based pricing strategy will be
- Sovereigns in emerging markets
- OECD Banks rated AAA or AA Non-OECD Bank rated A- or better
- NBFIs with higher ratings
- Corporate customers rated better than BBB. A good proxy is that Fair Default Risk i.e. grade 4.2 on the CRR for an unsecured credit equals c. 100% RWA.
- Non-rated corporate customer will also benefit from the internal rating of PD.
- A downgrade and rapidly deteriorating credit quality will result in steeply increased RWA value unless offsetting collateral is arranged. Thus pricing for poorly performing clients will increase.
- Undrawn committed facilities (Liquidity + Overdrafts) although usually granted to a customer with a very low PD (and even for less than 365 days) will attract capital. This is due to the minimum effective maturity of 1 year.
- Long dated facilities will attract higher capital (Although for RWA% Basel II caps the maturity factor at 5 years).
- An increased range of collateral will be eligible to mitigate exposures to optimise LGD.
Further preparations required by HSBC Bangladesh:
As part of the group requirement, HSBC Bangladesh has already taken the necessary steps to start reporting under IRB Advanced Approach of Basel II from 2009. It is expected that they will be well poised to adopt IRBA by 2008.
However, as the Bangladesh Bank decision to adopt Standardized Approach for the banks in Bangladesh has come only recently, preparations are yet to be made to meet the local reporting requirement also. Since under the Standardized Approach, most of the credit risk assessment responsibilities fall on the ECAI, adoption of the following steps by HSBC Bangladesh should be sufficient to ensure their compliance with the requirement of Bangladesh Bank.
- They should appoint the most competent ECAI to carry out credit ratings on behalf of their customers. The ECAI must have sufficient resources (both manpower and necessary knowledge of probability statistics, financial econometrics, times series analysis and market condition) to carry out high quality credit assessments. The ECAI should be able to perform independently in a fair manner and should not be subject to political or economic pressures that may influence the rating.
- They should thoroughly review the credit ratings carried out to ensure that there are no rating biases. High default culture in the financial market of Bangladesh indicates that existing weak regulatory framework for rating agencies may influence borrowers’ behavior to obtain good rating inappropriately.
- The reduced Standardised charges on retail lending could make such lending more attractive to banks. However, such exposure continues to be risky in the perspective of Bangladesh. HSBC should ensure that they hold an appropriate amount of capital to cover the heightened risk exposure from increased retail lending.
Globally Basel II accord will have significant impact in improving banks’ capital adequacy position and their internal mechanism and supervisory process. It will be beneficial to the commercial banks, as it requires review and measurement of different types of risk, which ultimately have effect on risk management approach to comply with the accord standards. Once implemented, banks would also be benefited with significant improvements in their risk management systems, business models, capital strategies and disclosure standards as well as overall efficiency. The idea of the new framework is to strengthen risk-based requirements by laying out principles for banks to assess the adequacy of their capital. It will also enable the supervisors to review such assessments to make sure that banks have adequate capital to support their risks.
The new Basel accord has been prepared on the basis of three pillars: minimum capital requirement, supervisory review process and market discipline. Three types of risks — credit risk, market risk and operational risk — have to be considered under the minimum capital requirement. For credit risk measurement, new framework provides two different methods – standardized approach and internal ratings-based approach. Implementation of standardized approach requires credit assessment intuitions or rating agencies for determining capital requirements of the banks in line with the Basel fixed risk-weight. On the other hand, internal rating based approach allows banks to rate their credit risks, which again have two different approaches — foundation approach and advanced approach.
HSBC Bangladesh will have to adopt the standardized approach for local regulatory requirement (as set out by Bangladesh Bank) while it will also adopt the IRB – Advanced Approach in line with group decision. Its capital adequacy position is not likely to be of any immediate concern under both the scenario, as HSBC Bangladesh is already very well capitalized (RCAR of 25% in 2005, as opposed to Basel II requirement of 8%). However, opportunities presented under Basel II (in the form of risk based pricing strategy, acceptance of different types of collateral, implementation of stringent credit risk assessment process etc should be utilized.
HSBC Bangladesh has already implemented most of the required steps for IRB Advanced Approach, and will be able to complete the whole process by 2008, ahead of the implementation deadline of 1st January 2009, as set out by the Group. It is also not likely to face any significant problem in the implementation of Standardized Approach, as most of the preparatory steps for Standardized Approach fall on the regulator and the ECAIs, and not on banks.
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