Basel I Basel II and Solvency II Chapter

Basel I, Basel II, and Solvency II Chapter XII

The Reasons for Regulating Banks • The purpose is to ensure banks keep enough capital for the risks they take. • Governments would like to make the probability of a bank failing small. • Governments would like to create and maintain a stable economic system.

Bank Regulation Pre-1988 • Prior to 1988, bank regulators tended to regulate bank capital by setting minimum levels for the ratio of capital to total assets. • The lack of consistency in several countries lead to a problem in which total assets were no longer a good indicator of the total risks taken.

The 1988 BIS Accord • Supervisory authorities from several countries formed the Basel Committee on Banking Supervision. • This is also known as The Accord or Basel I recently.

The Cooke Ratio • It considers both on-balance-sheet and offbalance-sheet items to calculate the bank’s total risk-weighted assets (amount). • It is a measure of the bank’s total credit exposure. • Each item on the on-balance-sheet item is assigned risk weight reflecting its credit risk.

The Cooke Ratio •

The Cooke Ratio Risk weight (%) Asset category 0 Cash, gold bullion, claims on OECD governments such as Treasury bonds or insured residential mortgages 20 Claims on OECD banks and OECD public sector entities such as securities issued by US government agencies or claims on municipalities 50 100 Uninsured residential mortgage loans All other claims such as corporate bonds and lessdeveloped country debt, claims on non-OECD banks Real estate, premises, plant, and equipment

Example • The assets of a bank consist of $100 million of corporate loans, $10 million of OECD government bonds, and $50 million of residential mortgages. The total of risk-weighted assets is 1. 0*100 + 0. 0*10 + 0. 5*50 = $125 million

The Cooke Ratio • Off-balance-sheet items are expressed as a credit equivalent amount. • Credit equivalent amount is the loan principal that is considered to have the same credit risk. • For non-derivatives the credit equivalent amount is calculated by applying a conversion factor to the principal amount of the instrument.

The Cooke Ratio • For an over-the-counter derivative, such as an interest rate swap or a forward contract, the credit equivalent amount is calculated as max(V, 0) + a. L • where V is the current value of the derivative to the bank, a is an add-on factor, and L is the principal amount. • The bank’s exposure is max(V, 0) and the add-on amount, a. L, is an allowance for the possibility of future exposure increasing.

The Cooke Ratio • The equation above is the current exposure. • If the counterpart defaults today and V is positive, the contract is an asset to the bank and the bank is liable to lose V. • However, if the counterpart defaults today and V is negative, the contract is an asset to the counterparty and there will be neither a gain nor a loss to the bank.

The Cooke Ratio Remaining maturity (years) Precious Other metals commod Exchange rate and gold Equity except gold ities Interest rate <1 0. 0 1. 0 6. 0 7. 0 10. 0 1– 5 0. 5 5. 0 8. 0 7. 0 12. 0 5> 1. 5 7. 5 10. 0 8. 0 15. 0

Example • A bank has entered into $100 million interest rate swap with a remaining life of four years. The current value of the swap is $2 million. In this case the add-on amount is 0. 5% of the principal, so that the credit equivalent amount is $2 million plus $0. 5 million, or $2. 5 million.