CAPITAL ADEQUACY Adapted from Saunders and Cornetts Textbook

CAPITAL ADEQUACY (Adapted from Saunders and Cornett’s Textbook, for class presentation only)© Unknown sfsu. edu

THE FIVE FUNCTIONS OF CAPITAL n 1. To absorb unanticipated losses with enough margin to inspire confidence and enable the FI to continue as a going concern. n 2. To protect uninsured depositors in the event of insolvency and liquidation. – n Capital protects non-equity liability holders against losses. 3. To protect FI insurance funds and the tax-payers. – An FI's capital offers protection to insurance funds and ultimately the taxpayers who bear the cost of insurance fund insolvency.

THE FIVE FUNCTIONS OF CAPITAL n 4. To protect the industry against increases in insurance premiums. – n By holding capital and reducing the risk insolvency, an FI protects industry from larger insurance premiums. 5. To fund new assets and business expansion. – FIs have a choice, subject to regulatory constraints, between debt and equity to finance new projects and business expansion.

US Capital Regulation U. S. banks are required to comply with two sets of capital regulation: n 1. the capital/asset (leverage) ratio: place banks into one of the five categories n 2. the risk-based capital requirements: comply with the Basel I regulation (only a few largest commercial banks are strictly required to follow Basel II) n

THE CAPITAL-ASSET (LEVERAGE) RATIO n n n The capital-assets or leverage ratio measures the ratio of a bank's book value of primary or core capital to the book value of its assets. Core capital L = -----------n Assets – – n The lower this ratio, the more highly leveraged the bank is. Primary or core capital is a bank's common equity (book value) plus qualifying cumulative perpetual preferred stock plus minority interests in equity accounts of consolidated subsidiaries. The FDICIA of 1991 assesses a bank's capital adequacy according to where its leverage ratio (L) places in one of five target zones.

THE CAPITAL-ASSET (LEVERAGE) RATIO n Specifications of Capital Categories for Prompt Corrective Action n Zone Leverage Total Risk Tier I Risk Capital _______________________________________________ Well Capitalized 5% or and 10% or and 6% or and Not subject to a capital above directive to meet a specific level for any capital measure Adequately 4% or and 8% or and 4% or and does not meet the Capitalized above definition of well capitalized n n n n Undercapitalized under 4% or under 8% or under 4% Significantly under 3% or under 6% or under 4% Undercapitalized Critically under 2% or under 2% Undercapitalized ________________________________________________

THE CAPITAL-ASSET (LEVERAGE) RATIO n Adequacy with the leverage ratio: – – – n Higher than 5 percent, well capitalized. At 4 percent or more, adequately capitalized; Less than 4 percent, undercapitalized; Less than 3 percent, significantly undercapitalized; and At 2 percent or loss, critically undercapitalized. Under the FDICIA legislation, prompt corrective action (PCA) would be taken when a bank falls outside zone 1, or the well under-capitalized category. – Most critically, a receiver must be appointed when a bank's book value of capital-assets (leverage) ratio falls to 2 percent or lower.

THE CAPITAL-ASSET (LEVERAGE) RATIO n Summary of Prompt Corrective Action Provisions of the FDIC Improvement Act of 1991: Zone Mandatory Discretionary Provisions _________________________________________ Well Capitalized None n Adequately capitalized 1. No brokered deposits except with FDIC approval None Undercapitalized 1. Suspend dividends and management fees 2. Require restoration plan 1. Order recapitalization n n n n 3. Restrict asset growth 4. Approval required for acquisitions, branching, and new activities 5. No brokered deposits 2. Restrict interaffiliate transactions 3. Restrict deposit rates 4. Restrict certain other activities 5. Any other action that would better carry out prompt corrective action

THE CAPITAL-ASSET (LEVERAGE) RATIO n n n n Significantly Undercapitalized 1. Same as for Zone 3 1. Any Zone 3 discretionary actions 2. Order recapitalizetion 2. Conservatorship or receivership if fails 3. Restrict interaffiliate to submit or implement plan or transactions recapitalize pursuant to order 4. Restrict deposit rates 3. Any other Zone 5 provisions if such 5. Pay of officers restricted action is not necessary to carry out prompt corrective action Critically 1. Same as for Zone 4 Undercapitalized 2. Receiver/conservator within 90 days 3. Receiver if still in Zone 5 four quarters after becoming critically undercapitalized 4. Suspend payments on subordinated debt 5. Restrict certain other activities _________________________________________

THE CAPITAL-ASSET (LEVERAGE) RATIO n n Problems with the Leverage Ratio as a measure of capital adequacy: 1. Market Value. – n 2. Asset Risk. – n Even if a bank is closed when its leverage ratio falls below 2 percent, a 2 percent book capital-asset ratio could be consistent with a massive negative market value net worth. By taking the denominator of the leverage ratio as total assets, the leverage ratio fails to consider, even partially, the different credit and interest rate risks of the assets that comprise total assets. 3. Off Balance-Sheet Activities. – Banks are nor required to hold capital to meet the potential insolvency risks involved with such contingent assets and liabilities of off-balance-sheet activities.

RISK BASED CAPITAL RATIOS n The 1993 Basel Agreement (Basel I) – n The 1998 Amendment – n Explicitly incorporated the different credit risks of assets into capital adequacy measures. Market risk was incorporated into risk-based capital in the form of an “add-on” to the 8% ratio for credit risk exposure. The 2006 New Basel Capital Accord (Basel II) – The incorporation (effective in 2006) of operating risk into capital requirements and updated the credit risk assessments in the 1993 agreement.

RISK BASED CAPITAL RATIOS n Regulators currently enforce the Basle Accord's risk-based capital ratios as well as the traditional leverage ratio. Their majorinnovation is to distinguish among the different credit risks of asset on the balance sheet and to identify the credit risk inherent in instruments off the balance sheet by using a risk adjusted assets denominator in these capital adequacy ratios.

RISK BASED CAPITAL RATIOS n A bank's capital is divided into Tier I and Tier II. – – – Tier I capital is primary or core capital. Tier II capital is supplementary capital. The total capital that the bank holds is defined as the sum of Tier I and Tier II capital.

RISK BASED CAPITAL RATIOS n Tier I capital is closely linked to a bank's book value equity reflecting the concept of the core capital contribution of a bank's owners. Basically, it includes: – – the book value of common equity; an amount of perpetual (nonmaturing) preferred stock; minority equity interests held by the bank in subsidiaries minus goodwill. Goodwill is an accounting item that reflects the amount a bank pays above market value when it purchases or acquires other banks or subsidiaries.

RISK BASED CAPITAL RATIOS n Tier II capital is a broad array of secondary capital resources. – It includes a banks loan loss reserves up to 3 maximum of 1. 25 percent of risk-adjusted assets plus various convertible and subordinated debt instruments with maximum caps.

RISK BASED CAPITAL RATIOS n n n Total Risk-Adjusted Assets = Risk-Adjusted On-Balance-Sheet Assets + Risk-Adjusted Off-Balance-Sheet Assets n n n n Risk-Adjusted Off-Balance-Sheet Assets = The Risk-Adjusted Asset Value of Off-Balance. Sheet Contingent Guaranty Contracts + The Risk-Adjusted Asset Value of Off. Balance-Sheet Market Contracts or Derivative Instruments

RISK BASED CAPITAL RATIOS n To be adequately capitalized, a bank must hold a minimum total capital (Tier I core capital plus Tier II supplementary capital) to risk-adjusted assets ratio of 8 percent; that is, its total risk-based capital ratio is calculated as Tier I Capital Total risk-based capital ratio = ----------------- 4% Risk-adjusted assets Total capital (Tier I plus Tier II) Total risk-based capital ratio = -------------------- 8% Risk-adjusted assets

Risk-Adjusted On-Balance-Sheet Assets n n n n n The Risk-Based Capital Standard for On-Balance-Sheet Items under Basel I: Risk Categories Assets ___________________________________ 1 (0% weight) Cash, Federal Reserve Bank balances, securities of the U. S. Treasury, OECD governments, and some U. S. agencies. 2 (20% weight) Cash items in the process of collection. U. S. and OECD interbank deposits and guaranteed claims. Some non-OECD bank and government deposits and securities. General obligation municipal bonds. Some mortgage-basked securities. Claims collateralized by the U. S. Treasury and some other government securities. 3 (50% weight) Loans fully secured by first liens on one- to four-family residential properties. Other (revenue) municipal bonds. 4 (100% weight) All other on-balance-sheet assets not listed above, including loans to private entities and individuals, some claims on non-OECD governments and banks, real assets, and investments in subsidiaries. ___________________________________

Risk-Adjusted On-Balance-Sheet Assets n n n n n (Items Added to) The Risk-Based Capital Standard for On-Balance-Sheet Items under Basel II: Risk Categories Assets ______________________________________ 1 (0% weight) Loans to sovereigns with an S&P credit rating of AA- or better. 2 (20% weight) Loans to sovereigns with an S&P credit rating of A+ to A-. Loans to banks and corporates with an S&P credit rating of AA- or better. 3 (50% weight) Loans to sovereigns with an S&P credit rating of BBB+ to BBB-. Loans to banks and corporates with an S&P credit rating of A+ to A-. 4 (100% weight) Loans to sovereigns with an S&P credit rating of BBB+ to B-. Loans to coporates with a credit rating of BBB+ to BB-. 5 (150% weight) Loans to sovereigns with an S&P credit rating below B-. Loans to corporates with an S&P credit rating below BB-. _____________________________________

Risk-Adjusted On-Balance-Sheet Assets n n n n Risk-adjusted On-Balance-Sheet Assets = Category 1 Assets * 0% + Category 2 Assets * 20% + Category 3 Assets * 50% + Category 4 Assets * 100% + Category 5 Assets * 150%

Risk-Adjusted On-Balance-Sheet Assets n n n n n n n A Bank’s Balance Sheet (Assets, $m) ______________________________________________ Weight Assets Amount ______________________________________________ Cash $5 0% Balance due from Fed 13 T-Bills 60 Long-term Treasury securities 50 GNMA securities 42 ________________________________________ 20% Items in process of collection 10 FNMA securities 10 Munis (general obligation) 20 AA+ rated loans of BOA 10 Commercial loans, AAA- rated 55 ________________________________________ 50% University dorm bonds (revenue) 34 Residential 1 -4 family mortgages 308 Commercial loans, A rated 75 ________________________________________ 100% Commercial loans, BB+ rated 390 Third world loans, B+ rated 108 Premises, equipment 22 ________________________________________ 150% Commercial loans, CCC+ rated 10 ________________________________________ N/A Reserve for loan losses (10)

Risk-Adjusted On-Balance-Sheet Assets n n n n n A Bank’s Balance Sheet (Liabilities, $m) _________________________________________ Liabilities/Equity Amount Capital Class _________________________________________ Demand deposits $150 Time deposits 500 CDs 400 Fed funds purchased 80 ______________________________________ Convertible bonds 15 Tied II Subordinated bonds 15 Tier II ______________________________________ Perpetual preferred stock (non-qualifying) 5 Tier I ______________________________________ Retained earnings 10 Tier I Common stock 30 Tier I Perpetual preferred stock (qualifying) 10 Tier I ______________________________________ Total $1, 215

Risk-Adjusted On-Balance-Sheet Assets n n n n n A Bank’s Balance Sheet (Off-balance-sheet, $m) _________________________________________ Weight Off-balance sheet Amount _________________________________________ 100% 2 -year loan commitments to a large BB+ rated $80 m U. S. corporation Direct credit substitute standby letter of credit $10 m issued to a BBB rated U. S. corporate Commercial letters of credit issued to a BBB- rated$50 m U. S. corporation ______________________________________ 50% One fixed floating interest rate swap for 4 years $100 m with notional dollar value of $100 m and replacement cost of $3 m One two-eay Euro$ contract for $40 m with a replacement $40 m cost of -$1 m _________________________________________

Risk-Adjusted Off-Balance. Sheet Activities n The calculation of the risk-adjusted values of the off balance-sheet (OBS) activities involves some initial segregation of these activities. – The credit risk exposure or the risk-adjusted asset amount of contingent or guaranty contracts, such as letters of credit or loan commitments, differs from the risk-adjusted asset amounts foreign exchange and interest rate forward, option, and swap contracts

The Risk-Adjusted Asset Value of Off-Balance. Sheet Contingent Guaranty Contracts n First step: multiply the dollar amount outstanding of these items by the conversion factors to derive the credit equivalent amounts. – These conversion factors convert an off-balance -sheet item into an equivalent credit or onbalance-sheet item.

The Risk-Adjusted Asset Value of Off-Balance. Sheet Contingent Guaranty Contracts Conversion Factors for Off-Balance-Sheet Contingent or Guaranty Contracts _________________________________ (100%): Sales and purchase agreements and assets sold with recourses that are not included on the balance sheet (100%): Direct credit substitute standby letters of credit (50%): Performance-related standby letter of credit (50%): Unused portion of loan commitments with original maturity of more than one year (20%): Commercial letters of credit (20%): Bankers acceptance conveyed (10%): Other loan commitment _____________________________________

The Risk-Adjusted Asset Value of Off-Balance. Sheet Contingent Guaranty Contracts n Second step: multiply these credit equivalent amounts by their appropriate risk weights. – The appropriate risk weight depends on the underlying counterparty, such as a municipality, a government, or a corporation, to the off-balance-sheet activity. n n n For example, if the underlying party being guaranteed were a municipality issuing general obligation (GO) bonds and a bank issued an off-balance-sheet standby letter of credit backing the credit risk of the municipal GO issue, the risk weight is 0. 2. If, on the other hand, the counterparty being guaranteed is a private entity, the appropriate risk weight is 1. Note that if the counterparty had been the central government, the risk weight is zero.

The Risk-Adjusted Asset Value of Off-Balance. Sheet Contingent Guaranty Contracts n Example: a bank with the following offbalance-sheet contingencies or guarantees: – – – 1. $80 m two-year loan commitments to large US corporations. 2. $10 m standby letters of credit backing an issue of commercial paper. 3. $50 m commercial letters of credit.

The Risk-Adjusted Asset Value of Off-Balance. Sheet Contingent Guaranty Contracts n Step 1: Credit Equivalent Amounts (CEA) n OBS item n n n Face Value Conversion Factor Credit Equivalent Amount _____________________________ Two-year loan commitment $80 *. 5 = $40 Standby letter of credit $10 * 1. 0 = $10 Commercial letter of credit $50 *. 2 = $10 _____________________________

The Risk-Adjusted Asset Value of Off-Balance. Sheet Contingent Guaranty Contracts n Step 2: Risk-Adjusted Asset Amount n OBS item n n n n Credit Risk-Adj. Equivalent Weight Asset Amount _____________________________ Two-year loan commitment $40 * 1. 0 = $40 m Standby letter of credit $10 * 1. 0 = $10 Commercial letter of credit $10 * 1. 0 = $10 Total $60 m _____________________________

The Risk-Adjusted Asset Value of Off. Balance-Sheet Market Contracts or Derivative Instruments n n Modem FIs engage heavily in buying and selling OBS futures, options, forwards, swaps, caps, and other derivative securities contracts for interest rate and foreign exchange (FX) management and hedging reasons and to buy and sell such products on behalf of their customers. Each of these positions potentially exposes banks to counterparty credit risk, that is, the risk that the counterparty (or other side of contract) will default if it suffers large actual or potential losses on its position. Such defaults mean that a bank must go back to the market to replace such contracts at (potentially) less favorable terms.

The Risk-Adjusted Asset Value of Off. Balance-Sheet Market Contracts or Derivative Instruments n Two-Step Approach for calculating the risk-adjusted asset values of OBS market contracts: – – n First, convert to the credit equivalent amount with a conversion factor for each derivative instrument. Second, multiply the credit equivalent amounts by the appropriate risk weights. The credit equivalent amount itself is divided into a potential exposure element and a current exposure element. Credit equivalent amount of OBS Derivative security items = Potential exposure ($) + Current exposure ($)

The Risk-Adjusted Asset Value of Off. Balance-Sheet Market Contracts or Derivative Instruments n The Potential Exposure: – – – The potential exposure conversion component reflects the credit risk if the counterparty to the contract defaults in the future. The probability of such an occurrence depends on future volatility of either interest rates for an interest rate contract or exchange rates for an exchange rate contract. The Bank of England the Federal Reserve performed an enormous number of simulations and found that FX rates are far more volatile than interest rates. Thus, the potential exposure conversion factors are larger foreign exchange contracts than for interest rate contracts.

The Risk-Adjusted Asset Value of Off. Balance-Sheet Market Contracts or Derivative Instruments n Credit conversion factors for Interest Rate and Foreign Exchange Contracts in Calculating Potential Exposure: n Remaining Interest Rate Exchange Rate Maturity Contracts ________________________ Less than one year 0% 1. 0% One to five years 0. 5% 5. 0% Over five years 1. 5% 7. 5% ________________________ n n n

The Risk-Adjusted Asset Value of Off. Balance-Sheet Market Contracts or Derivative Instruments n The Current Exposure: – – – This reflects the cost of replacing a contract should a counterparty default today. The bank calculates this replacement cost or current exposure by replacing the rate or price initially in the contract with the current rate or price for a similar contract and recalculates all the current and future cash flows that the current rate or price terms generate. The bank discounts any future cash flows to give a current present value measure of the contract's replacement cost. If the contract's replacement cost is negative, the replacement cost (current exposure) to be set to zero. If the replacement cost is positive (i. e. , the contract is profitable to the bank but it is harmed if the counterparty defaults), this value is used as the measure of current exposure.

The Risk-Adjusted Asset Value of Off. Balance-Sheet Market Contracts or Derivative Instruments n Once we total the current and potential exposure amounts to produce the credit equivalent amount for each contract, we multiply this dollar number by a risk weight to produce the final risk-adjusted asset amount for OBS market contracts.

The Risk-Adjusted Asset Value of Off. Balance-Sheet Market Contracts or Derivative Instruments n Example: Suppose the bank in the previous example has take on interest rate hedging position in the fixed-floating interest rate swap market for 4 years with a notional dollar amount of $100 m and one two-year forward foreign exchange contract for $40 m. Calculate the credit equivalent amount for each contract.

The Risk-Adjusted Asset Value of Off. Balance-Sheet Market Contracts or Derivative Instruments n n n Potential Exposure + Current Exposure Contract Notional Conversion Potential Replacement Current Credit Principal Factor Exposure Costs Exposure Equiv. ____________________________________ 4 -year fixed$100 m *. 005 = $. 5 m $3 m $3. 5 m Floating interest Rate swap 2 -year forward $40 m *. 050 = $2 m -$1 m $0 m $2 m Foreign Exchange Contract ____________________________________ Total Credit Equivalent Amount $5. 5 m

The Risk-Adjusted Asset Value of Off. Balance-Sheet Market Contracts or Derivative Instruments n To calculate the risk-adjusted asset value for the bank’s OBS derivative or market contracts, multiply the credit equivalent amount by the appropriate risk weight, which under the Basel I is generally. 5 or 50%: n Credit Risk-Adjusted Asset Value of OBS Derivatives n n n = $5. 5 m * 0. 5 = $2. 75 m Under Basel II, the risk weight assigned to the credit equivalent amount, $5. 5 m is 100%. Thus, the credit riskadjusted value of the OBS derivatives is $5. 5 m.

Criticisms of the Risk. Based Capital Ratio n The risk-based capital requirement seeks to improve on the simple leverage ratio by – – – n more systematically accounting for credit risk differences among assets, incorporating off-balance-sheet risk exposures, and applying a similar capital requirement across all the major banks (and banking centers) in the world. .

Criticisms of the Risk. Based Capital Ratio n Risk weights. It is unclear how closely the four risk weight categories reflect true credit risk. – For example, residential mortgage loans have a 50 percent risk weight; commercial loans have a 100 percent risk weight. Taken literally, these relative weights imply that commercial loans are exactly twice as risky as mortgage loans.

Criticisms of the Risk. Based Capital Ratio n Balance sheet incentive problems. The fact that different assets have different risk weights may induce bankers to engage in balance sheet asset allocation games. – For example, residential mortgages have a 50% risk weight, and GNMA mortgage-backed securities have 0% risk weight. Suppose that a bank pools all its mortgages and then sells them to outside investors. If it then replaced the mortgages it sold with GNMA securities backing similar pools of mortgages to those securitized, it could significantly reduce its riskadjusted asset amount.

Criticisms of the Risk. Based Capital Ratio n n Portfolio aspects. The new plan also ignores credit risk portfolio diversification opportunities. When returns on assets have negative or less than perfectly positive correlations, an FI may lower its portfolio risk through diversification. The new capital adequacy plan is essentially a linear risk measure that ignores correlations or covariances among assets and asset group credit risks, such as between residential mortgages and commercial loans. That is, the banker weights each asset separately by the appropriate risk weight and then sums those numbers to get an overall measure of credit risk.

Criticisms of the Risk. Based Capital Ratio n n Bank specialness. Giving private sector commercial loans the highest credit risk weighting may reduce the incentive for banks to make such loans relative to holding other assets. This may reduce the amount of bank loans to business as well as the degree of bank monitoring and may have associated negative externality effects on the economy. That is, one aspect of banks' special functions-bank lending--may be muted. Equal weight of all commercial loans. Loans made to an AAA-rated company have a credit risk weight of 1, as do loans made to a CCC-rated company. That is, within a broad risk-weight class such as commercial loans, credit risk quality differences are not recognized. This may create perverse incentives for banks to pursue lower-quality customers, thereby increasing the risk of the bank.

Criticisms of the Risk. Based Capital Ratio n Other risks. Although market risk exposure has now been integrated into the risk-based capital requirements, the plan does not yet account for other risks such as foreign exchange rate risk, asset concentration risk, and operating risk. A more complete risk-based capital requirement would include these risks.

Criticisms of the Risk. Based Capital Ratio n Competition. As a result of tax and accounting differences across banking systems and in safety net coverages, the 8 percent risk-based capital requirement has not created a level competitive playing field across banks as intended by many proponents of the plan. In particular, Japan and the United States have very different accounting, tax, and safety net rules that significantly affect the comparability of U. S. and Japanese bank risk-based capital ratios. The provisions of the Basle Accord also allow differences in bank capital rules to persist among countries. Different capital elements are allowed for both Tier I and Tier II capital across countries. Also, many countries use a 10 percent risk category that is not used in the United States.

Objectives of the New Basel Accord n The objectives of Basel II are to encourage better and more systematic risk management practices, especially in the area of credit risk, and to provide improved measures of capital adequacy for the benefit of supervisors and the marketplace more generally.

Objectives of the New Basel Accord n The three pillars approach to capital adequacy involving n (1) minimum capital requirements, (2) supervisory review of internal bank assessments of capital relative to risk, and (3) increased public disclosure of risk and capital information sufficient to provide meaningful market discipline. n n

Key Elements of the New Basel Accord n Pillar 1: Two Approaches for Assessing Credit Risk n The standardized approach incorporates modest changes in risk sensitivities to improve risk sensitivities through readily observable risk measures such as external credit ratings. n Consistent with the Basel Committee’s objectives, it is intended to produce a capital requirement more closely linked to each bank’s actual credit risks – a lower-quality portfolio will face a higher capital charge, a higher-quality portfolio a lower capital charge.

Key Elements of the New Basel Accord n Pillar 1: Credit Risk n The IRB approach is based on four key parameters used to estimate credit risks: n 1. PD: n 2. LGD: n 3. EAD: n 4. M: The probability of default of a borrower over a one-year horizon The loss given default (or 1 minus recovery) as a percentage of exposure at default Exposure at default (an amount, not a percentage) Maturity

Key Elements of the New Basel Accord n Pillar 1: Credit Risk n For a given maturity, these parameters are used to estimate two types of expected loss (EL). n Expected loss as an amount: n EL = PD * LGD * EAD n and expected loss as a percentage of exposure at default: n EL% = PD * LGD

Key Elements of the New Basel Accord n Pillar 1: Credit Risk n The two variants of IRB, the foundation approach and the advanced approach, differ principally in how the four parameters can be measured and determined internally, but an essential feature of both approaches is their use of the bank’s own internal information on an asset’s credit risk. n In the advanced approach all four parameters are determined by the bank and are subject to supervisory review.

Key Elements of the New Basel Accord n n Pillar 1: Credit Risk For the foundation approach: n 1. Only PD may be assigned internally, subject to supervisory review (Pillar 2). n 2. LGD is fixed and based on supervisory values. For example, 45% for senior unsecured claims and 75% for subordinated claims. n 3. EAD is also based on supervisory values in cases where the measurement is not clear. For instance, EAD is 75% for irrevocable undrawn commitments. n 4. Finally, a single average maturity of three years is assumed for the portfolio.

Key Elements of the New Basel Accord n Pillar 1: Credit Risk n A critical issue with respect to the IRB approach is the reliability of the credit risk parameters supplied by banks, upon which the capital charges are based. n If these estimates prove unreliable, the IRB approach would provide little, if any, improvement in risk sensitivity over the current Accord. n Thus, it is essential that prior to IRB implementation supervisors ensure that a bank’s internal processes for determining internal risk ratings, PDs, LGDs, and EADs are credible and robust.

Key Elements of the New Basel Accord n Pillars 2 and 3: Supervisory review and public disclosure n Pillar 2 provides a basis for supervisory intervention to prevent unwarranted declines in a bank’s capital. The Basel Committee has articulated four principles consistent with these objectives: n (1) Each bank should assess its internal capital adequacy in light of its risk profile, n (2) Supervisors should review internal assessments, n (3) Banks should hold capital above regulatory minimums, and n (4) Supervisors should intervene at an early stage.

Key Elements of the New Basel Accord n Operational Risk: 3 Flavors n Operational risk is defined as “the risk of direct of indirect loss resulting from inadequate or failed internal processes, people and systems or from external events” n Developing a capital charge for operational risk is challenging both because of a lack of agreed methodology, and because of limited historical loss data.

Key Elements of the New Basel Accord n Operational Risk: 3 Approaches n The Basic Indicator approach provides a simple way to determine a capital requirement, based on a percentage of gross income. n The Standardized approach assigns a capital charge for each of eight business lines based upon a fixed relation between average industry allocated economic capital and gross income for each business line. n Finally, through the Advanced Measurement approach (AMA) the Committee sought to provide flexibility for banks to use their own internal measurement approaches.