Capital Requirements Under Basel - II with Exercises

Dr. Prashanta K. Banerjee Senior Associate Professor and Director (RD&C) , BIBM

Minimum Capital Requirement (MCR) ( Credit + Market Risk+ Operational Risk)

Risk Weighted Amount For Credit Risk For Market Risk ............ 10 = .............. .............. 10 =.................. .................. 10% of RWA =................. 10% =............ Cr. Tk.

For Operational Risk

Total: RWA Minimum Capital Requirement (MCR)

Assets to be defined by type of claims and other category under Standardized Approach
Claims on Bangladesh Govt. and Bangladesh Bank Claims on other sovereigns and central banks Claims on Multilateral Development Banks (MDBs) Claims on Public Sector Entities (other than Government) in Bangladesh Claims on Banks Claims on corporates Claims included in the retail & Small portfolios (excluding consumer Finance) Consumer Finance Claims secured by residential property Claims secured by commercial real estate Other Categories: Past due loans Other assets Off-balance sheet items

Assets to be Segregated into Trading & Banking Books

Trading Issues Held for trading (HFT) Available for sale (AFS) Equities

Foreign Exchange held throughout the both trading & banking

book

Commodities held throughout the both trading & banking book

Banking Issues All other except trading book issue

RISK MITIGATION

Basel II permits reducing exposure by value of eligible collateral

Haircut' is providing for fluctuation in value of collateral (reduced
realizable value at the point of realization) and/ or of exposure

(increase in exposure due to interest, legal costs, etc, once

default occurs)

Guarantors risk weight can be taken where lower than the

borrowers risk weight

Credit Risk Mitigation Guarantees

Guarantees given by :

Govt. or Central Bank

constituent.

eligible for lesser RW than borrower-

Schedule Banks eligible for lesser RW than borrower-constituent. BIS/IMF/ eligible for lesser RW than borrower-constituent. Other counter-parties Rated AA or better.
Note: Guaranteed portion of outstanding will be shown in respective

bucket of the Guarantor. Unguaranteed portion will be shown in the

respective bucket of the counterparty/borrower-constituent.

Haircuts Formulae
New concept born out of Basel II Haircut is intended to increase the value of the Exposure and reduce the value of the Collateral E* = max { 0, [E x (1 + He) C x (1- He Hfx)] }, where E* = the Exposure value after Risk Mitigation E = current value of the Exposure for which the Collateral qualifies as a Risk Mitigant. C = current value of the Collateral held He = haircut appropriate to the Exposure (%) Hc = haircut appropriate to the Collateral (%) Hfx = haircut appropriate to the Collateral for Currency Mismatch between the Collateral and Exposure (%) This formula can be further sub-divided into 2 parts, one for the Exposure (E) and another for Collateral (C) as under: Value of Exposure after Haircut = E x (1+He) Value of Collateral after Haircut = C x (1 - He - Hfx)

Example-1 (contd.) Trading Book (Tk. in Crore)

SI. No. 1. 2. 3. Details F. Cy clearing A/c Balance with banks abroad (Nostro A/C)

Tk. in Crore 20
10 1100

Investments: Market Value Held for Trading (HFT) 500 Other (HFT) 300 Equities 300
Export & other foreign bill (Purchase/Dis) Total Investment in trading

4. 5.

100 1230

Example-1 (contd.) Banking Book : RWA for Credit Risk (Tk. in Crore)
Sl.No.
1.

Details
Cash and Balance with BB (Less F. Ex)

Book Value
180

2. 3.
4. 5. 6.

Bank Balances (At) Investments: Held to Maturity (HMT) - Government 500 Advances Other Assets
Total Assets:

190 500

2700 200 3770

Credit Risk: Calculation of Risk Weighted Asset on Banking Book

Credit risk is defined as the risk of losses in both on & off
balance sheet positions of banking book arising from violation of agreement by a counterparty

Risk Weighted Asset (RWA) to be calculated taking factors in

consideration under Standardized Approach

Risk weight mapped against Different ratings of ECAls

Credit Risk Mitigation (applying Haircut on Exposures & Eligible

Collateral Values)

Eligible Guarantor &

Specific Provision

Table no. 1 (Mapping ECAIs Rating with BB)

BB Rating Grade
1 2 3 4 5 6

Equivalent Rating of CRAB **

AAA AA1,AA2 AA3,A1,A2,A3 BBB 1,BBB2,BBB3 BB 1, BB2, BB3, B1 etc. CCC3, CC, C, D)

Equivalent Rating of CRISL **

AAA AA +, AA AA-, A+, A, ABBB+, BBB etc. BB+, BB etc. CC+, CC etc.

Table-2: Rating mapped with risk weight (Possible scenario)

Credit Assessment RatingCounter-parties 1 Claims on Government & Central Bank Claims on Banks & Fls Opt 120% 0% 2,3 4 5 100% 100% 6 150% 150% Unrated 100% 100%

20% 50% 50% 100%

1 Corporate 20%

3,4

5,6 150%

Unrated 100%

50% 100%

Continuation of Table-2 : Other Category of Assets (As stated in Basel II document)

Category of Assets Cash items Claims secured by cash or Gold Claims secured by residential Property Risk Weight

0% 0% 75% 75%
100% 100% 100% 75%

Retail & Small Portfolio (excluding consumer financing)

Consumer financing Claims secured by real estate Past due loan, Specific provisions<20% of the outstanding amount Past due loan, Specific provisions>20% of the outstanding amount

Table-3 : Haircuts for Exposures Haircuts for Exposures expressed as percentages ( to be fixed by supervisory authority) may be as follows:
Exposures Residual Maturity 1 1 year >1 year, 5 years 2 4 1 Sovereigns 0.5 Other issuers 1 4 8 2

2,3

> 5 years 1 year

>1 year, 5 years

4 > 5 years 5 years > 5 years

3
6 9 12

6
12 12 15 25

5,6 and unrated

All

15

Table-4 : Haircuts for Collateral Haircuts for Collateral expressed as percentages ( to be fixed by supervisory authority) may be as follows:
Issue rating for debt Residual Maturity securities 1 & S1 1 year > 1 year, 5 years > 5 years 1 year >1 year, 5 years > 5 years 4, 5.6, S4 & Unrated All Sovereigns 0.5 2 4 1 3 6 Other Issues 1 4 8 2 6 12 15 Continued to next slide

2,3,S2 & S3

Example-1 (contd.) Banking Book : RWA for Credit Risk (Tk. In Crore)
Sl. No.
1.

Details
Cash and Balance with BB (Less F. Ex)

Book Value
180

RW (%)
0

RWA
0

2.
3. 4. 5. 6. 7.

Bank Balances (1)

Investments: Held to Maturity (HMT) - Government Advances Other Assets Total Assets: Total RWA 500

190
500 2700 200 3770

20
0 Next Slide 100

38

1985 200

2223

Example-1 (contd.) Banking Book : RWA for Credit Risk (Tk. In Crore)
SI. No. 4. 4.a Details Advances Corporate Claims Secured by Res-property (Rate-2) Claims Secured by Real-estate (Rate-2) 7 Cases (secured by financial collateral ) Retail & Small (excluding consumer) Consumer financing Classified Secured & kept provision (26 Cr.) <20% Secured & kept provision (64 Cr.) > 20%

Book Value

RW (%)

RWA

200 275
700 300 725 200 300

4.c 4.d 4.e 4.f

75 100 calculation sheet 75 100

100 75

150 275
259 225 725 174 177

Total:

2700

1985

Calculation Sheet (7 cases of credit exposure secured by Financial Collateral)

Case-1 Case-2 Case-3 Amount Maturity of Exposure (Yrs) 100 2 100 3 100 6 Case-4 Case-5 Case-6 Case-7 100 2 100 3 100 3 100 3

Nature of Exposure
Currency Rating of Exposure Haircut of exposure (From Table-3)

Corp
BDT 4

Corp
BDT 2

Corp
USD 4

Corp
BDT Unrated

Corp
BDT 1

Corp
BDT 5

Corp
BDT 5

0.12

0.06

0.12

0.25

0.04

0.25

0.25

Case 4, 6 & 7 : The haircut for the exposure is the highest as applicable to other equities

Calculation Sheet - contd. (Financial Collateral received to secure 7 cases respectively)

Case-1 Case-2 Case-3 Case-4 Amount Maturity of collateral (vro Nature of collateral 100 2 100 3 100 6 100 Case-5 125 Case-6 Case-7 100 3 Corp Bond BDT 1 0.04 100 0.5 Corp Bond BDT s3 0.06

PSE

Bank Corp Bond Bond BDT titivate d 0.06 BDT 2 0.12

Equity Equity outside in main main index index BDT BDT 0.15 0.12

Currency Rating of collateral

BDT 3

Haircut of collateral (From Table-4) 0.03

Haircut for currency mismatch 0.08 (From Table-4) Case 5 : As value of the collateral is higher than the exposure after haircuts, the exposure is zero

Calculation Sheet- contd. (Net Exposure & calculation of RWA)

Exposure after haircut E (1 + He) Collateral after haircut C (1 11c- 11fx ) Net Exposure Risk weight RWA Case-1 Case-2 112 106 97 15 100% 15 94 12 50% 6 Case-3 112 80 32 100% 32 Case-4 Case-5 Case-6 Case-7 125 104 125 75 50 125% 62.5 110 96 100 100% 100 259

0 29 20% 150% 0 43.5 Total RWA =

E*= max {0, [E (1 + He) C (1 - He - Hfx)]} where: E* = Exposure value after risk mitigation, E = Current value of the exposure, He = Haircut appropriate to the exposure, C= Current value of the collateral received. He = Haircut appropriate to the collateral. Hfx = Haircut appropriate for currency mismatch between the collateral and exposure Case-1 : E* = 100 (1 + 0.12) 100 (1- 0.03) = 112 - 97 = 15 Case 7 : Ineligible for CRIvt since the maturity of the collateral is less than one year and rating is B -

Minimum Capital Requirement (MCR) ( Credit + Market Risk+ Operational Risk)

Risk Weighted Amount Cr. Tk.

For Credit Risk

For Market Risk For Operational Risk Total: RWA Minimum Capital Requirement (MCR) 10% of RWA =.. 10% =

2223.00
.. 10 = .. 10 =

Trading Issues & Market Risk

Market risk is defined as the risk of losses in both on & off balance sheet positions arising from movements in market prices The market risks subject to the capital requirement under standardized approach include: a) the risk pertaining to Interest rate instruments in the trading book b) the risk pertaining to equities in the trading book c) foreign exchange risk throughout the bank and d) commodity risk throughout the bank.

Capital Charge for Market Risk Components

In Standardized Approach the capital requirement for various market risks is determined separately. Market Risk Components are: Interest Rate risk -Specific Risk -General Market Risk Equity Price risk -Specific Risk -General Market Risk Exchange Rate risk - General Market Risk Commodity Price risk -General Market Risk

Table-5: Specific risk capital charge for Interest Rate Instrument

Categories Government ( Domestic Currency) Government ( Other than Domestic Currency) 1 2-3 0% 0.25% (residual term to final maturity 6 months or less) External Rating Grade Specific risk capital charge 0%

1.00% (residual term to final maturity

greater than 6 and up to and including 24 months) 1.60% (residual term to final maturity exceeding 24 months) 4-5 8%

12%
Continued to next slide

Table-5: Specific risk capital charge (contd.)

Categories Qualifying External Rating Grade 2-3 Specific risk capital charge 0.25% (residual term to final maturity 6 months or less) 1.00% (residual term to final maturity greater than 6 and up to and including 24 months) 1.60% (residual term to final maturity exceeding 24 months)

Other

1
2,3 4

2%
6% 10%

Below 4 Unrated

12% 10%

Clarification
The category "government" will include all the existing approved government securities and such other government securities as may be notified by BB from time to time. All BDT denominated government securities will be risk weighted at zero percent while for foreign currency denominated securities whether issued by domestic or foreign governments, the criteria given in the above table would apply. Qualifying Category: Debt securities issued by public sector entities and multilateral development banks, and other securities that is recognized by BB for including in this category. A debt security rated by at least two credit rating agencies of the approved panel of BB and if both rating is equivalent and rated at least 3 or S3

Table-6: Maturity Method: Time bands and weights (Used to calculate General Market Risk of Interest Rate Instruments)
Coupon 3% or more 1 month or less Over 1 to3 months Over 3 to 6 months Over 6 to12 months Coupon Less than 3% 1 month or less Over 1 to3 months Over 3 to 6 months Over 6 to12 months RW Assumed Changed in Yield 1.00 1.00 1.00 1.00

0.00% 0.20% 0.40% 0.70%

Over 1 to 2 Years Over 2 to 3 Years Over 3 to 24 Years

Over 1 to 2 Years Over 2 to 3 Years Over 3 to 24 Years

1.25% 1.75 % 2.25 %

0.90 0.80 0.75

Continued to next slide

Table-6: Maturity Method: Time bands and weights (contd.)

Coupon 3% or more Coupon Less than 3% RW Assumed Changed in Yield 0.75 0.70 0.65 0.60 0.60 0.60 0.60 0.60

Over 4 to 5 Years Over 5 to 7 Years Over 7 to 10 Years Over 10 to l5Years Over 15 to 20Years Over 20 Years

Over 3.6 to 4.3 Years Over 4.3 to 5.7 Years Over 5.7 to 7.3 Years Over 7.3 to 9.3 Years Over 9.3 to 10.6 Years Over 10.6 to 12 Years Over 12 to 20 Years Over 20 Years

2.75% 3.25 % 3.75% 4.50% 5.25% 6.00% 8.00% 12.50%

Example-1 (contd.) Trading Book (Tk. in Crore)

Sl. No.
1. 2.

Details
F. Cy clearing A/c Balance with banks abroad (Nostro A/C) Investments: Held for Trading-Goyt. (HFT) Other (HFT) Equities Market Value 500 300 300

Tk. in Crore
20 10

1100

3.

4. 5.

Export & other foreign bill (Purchase/Dis) Total Investment in trading

100 1230

Example -1 (contd.) Capital Charge for Specific risk against Interest rate instruments
Counter Party Maturity Amount (Market Value) (Tk in cr.) 200 300 100 Weight (%) (From Table-5) 0 0 0.25 Capital Charge (Tk in cr.) 0 0 0.25

Govt. Govt. Qualifying

2 months 12 years 2 months

Qualifying
Qualifying Other (unrated) Other (unrated) Total:

4 years
6 years 3 months 5 months

90
70 30 10 800

1.60
1.60 10 10

1.44
1.12 3.00 1.00 6.81

Example -1 (contd.) Calculation of General Market Risk against Interest rate instruments(Maturity Method)
Counter Party Govt. Govt. Qualifying Qualifying Qualifying Other Other Amount Maturity 2 months 12 years 2 months 4 years 6 years 3 months 5 months (Market Value) 200 300 100 90 70 30 10

Weight (%) (From fable 6)

0.20 4.50 0.20 725 3.25 0.20 0.40

Weighted Position 0.40 13.5 0.20 2.025 2275 0.06 0.04

Total:

800

18.50

Calculation of Capital charge for Equities from Example-1

There are equity instruments in the trading book. Amount of Equities as mentioned in the banking companies balance sheet is Tk 300 Crore. Therefore, Specific Risk for equities is 10% of 300= Tk. 30.00 crore and General Market Risk for equities is 10% of 300 = Tk. 30.00 crore

Example-1 (contd.) Capital Charge on FCy. Positions

US Dollar US dollar Japanese yen USD JPY Long/Short position in USD equivalent (inn) -18 +5 Taka Equivalent (mn) -1080 +300

Swiss franc
Pound Sterling Euro Canadian Dollar Australian Dollar Singapore dollar Other Currencies

CHF
GBP EUR CAD AUD SGD

+15 +10 -2 -3.5 -

+900 +600 -120 -210 -

Example-1 (contd.) Capital Charge on FCy. Positions

US Dollar Long/Short position in USD equivalent (mn) +30 -23.5 30 10% 3.0 Taka Equivalent (mn) +1800 -1410 1800 10% 180

Sum of the net long position Sum of the net short position Overall net position* Risk weight Capital charge for FX Exposure

The overall net position shall be greater one of the absolute value of the sum of the net long or the sum of short position. The example assumes a current spot market exchange rate of Taka 60 per US$ 1.

From Example-1 Total Capital Charge for Market Risk (Without derivatives in trading book)
Details

Capital Charge for Specific Risk (Cr)

6.81 30.00 36.81

Capital Charge for General Market Risk (Cr) 18.50 30.00 18.00 66.50

Interest Rate Related Equities FOREX Position Total: Total Charge Amount

36.81 +66.50 = 103.31 Cr. Tk.

Minimum Capital Requirement (MCR) ( Credit + Market Risk+ Operational Risk)

Risk Weighted Amount
For Credit Risk For Market Risk For Operational Risk Total: RWA Minimum Capital Requirement (MCR) 10% of RWA Cr. Tk. 2223.00 103.31 10 =1033.10 . 10 =............ ..

=.. 10%
=..

Operational Risk: Basic Indicator approach

KBIA = [(GI1---n 1----n)]/n Where KBIA = the capital charge under the Basic Indicator Approach GI = annual gross income, where positive, over the previous three years n = number of the previous three years for which gross income is positive =15%,which is set by the BCBS

Capital charge for Operational Risk

Suppose last 3 years GIs are as follows: GI 1 = 174.00 Cr. Tk. GI 2 = 52.00 GI 3 = 155.00

Capital charge for Operational Risk:

K = [(GI 1 + GI2 + GI3)* ]/n = [(174.00+ 52.00+155.00) 15%]/3

= [(381.00) 15%]/3
= 57.15/3 = 19.05 Crore

Minimum Capital Requirement (MCR) ( Credit + Market Risk+ Operational Risk)

Risk Weighted Amount

For Credit Risk For Market Risk For Operational Risk Total: RWA Minimum Capital Requirement (MCR)

Cr. Tk. 2223.00

103.31 10 =1033.10 19.05 10= 190.50 3446.60

10% of RWA
= 3446.60 10% = 344.66 Cr. Tk.