BASEL II AT GLANCE. Implementation of Basel II in Indonesia. Bank Indonesia Directorate of Banking Research and Regulation

Transcription

1 BASEL II AT GLANCE Implementatin f Basel II in Indnesia Bank Indnesia Directrate f Banking Research and Regulatin 1

2 Table f Cntents Frewrd Basel II at a Glance Bank Capital The Capital Adequacy Rati (CAR) Definitin f Regulatry Capital Minimum Capital Rati Risk Weightings EStructure f Basel II Basel Capital Accrd Pillar 1 Definitin f Capital, Mitigatin f Credit Risk Market Risk, Operatinal Risk Pillar 2 Supervisry Review Prcess Pillar 3 Market Disclsure Frequently Answered Questins Glssary 2

3 Frewrd The purpse f this bk is t help readers understand the imprtance f capital, nt nly fr individual banks, but als in safeguarding financial system stability. Because f this vital rle, the regulatin f bank capital is guided by internatinal standards issued by the Basel Cmmittee n Banking Supervisin. The Basel I standard, initially adpted in 1988, has undergne numerus changes ver time in respnse t the rapid develpment f financial market instruments. Ultimately, agreement was reached n a mre risk sensitive standard fr calculatin f bank capital knwn as Basel II. This simply-wrded bk is designed t infrm readers f the prcess f change in capital standards and the backgrund t the issuance f Basel II, in which bank capital adequacy is linked t the risk prfile f the individual bank. This bk des nt delve int the in depth technical detail n each aspect f Basel II, but rather is aimed mre at presenting a cmmn line f thught fr Basel II, that f imprving bank risk management in rder t prvide better assurance f financial system stability, which will ultimately supprt ecnmic grwth. Jakarta, September

4 Basel II at a Glance Imprved Standard fr Capital Adequacy A bank prvides an intermediatin functin fr funds received frm custmers. Failure f a bank will result in widespread impact affecting retail and institutinal custmers wh hld funds at the bank. This culd trigger multiplier impacts n t he dmestic and internatinal market. The imprtance f the banking rle demands prper regulatin, in which the primary bjective is t maintain custmer cnfidence in the banking system. An essential part f the regulatry framewrk fr the banking system invlves the regulatins gverning bank capital, which functins as a buffer against lsses. In view f the imprtance f capital t banks, BIS issued a capital framewrk cncept mre cmmnly knwn as the 1988 accrd (Basel I). This system was designed as a framewrk fr measurement f credit risk and established a minimum capital standard at 8%. The Basel Cmmittee designed Basel I as a simple standard requiring banks t disaggregate their expsures int brader categries reflecting debtr similarities. Expsures t custmers f the same type (such as expsures t all crprate custmers) are subject t the same capital requirements withut taking accunt f differences in lan repayment capacity and specific risks assciated with the individual custmer. Mre than a decade later, prmpted by the evlutin f banking wrldwide and the reality that the best methd fr calculating, managing and mitigating risks wuld be different frm bank t bank, the Basel Cmmittee embarked n the initiative fr revisin f Accrd The grwing diversity and sphisticatin f prducts in the banking system led BIS t intrduce imprvements t the capital framewrk in the 1988 accrd with the launching f a new capital cncept knwn as Basel II. The first prpsal w as released in 1999 and was slated fr implementatin at end The revised capital accrd Basel II is a cmprehensive agreement that establishes a spectrum f mre risk-sensitive capital allcatin and incentive fr imprvements in the quality f risk management at banks. This was achieved by adjusting capital requirements t credit risk and peratinal risk, and intrducing changes in calculatin f capital t cver expsures t risks f lsses caused by peratinal failures. In additin t the calculatin f minimum bank capital, Basel II als prvides fr a supervisry review prcess t ensure that banks maintain a level f capital cmmensurate t their risk prfile and prmtes market discipline thrugh disclsure requirements. BASEL II 3 PILLARS MINIMUM CAPITAL REQUIREMEN SUPERVISORY REVIEW PROCESS MARKET DISCIPLINE Prviding a flexible, risk-sensitive capital management framewrk The bjective f Basel II is t strengthen the security and sundness f the financial system by reinfrcing the emphasis n risk-based calculatin f capital, the supervisry review prcess and market discipline. The Basel II Framewrk is based n a frward- 4

5 lking apprach that enables imprvements and changes t be made ver time. In this way, the Basel II framewrk is able t keep pace with changes in the marketplace and develpments in risk management. At first glance, Basel II invlves varius cmplexities and precnditins that are difficult fr banks t meet. Hwever, the extra effrt is well justified in view f the benefits t banks frm mre ecnmic use f capital in cvering their risks. Banks als benefit frm the internatinal recgnitin f the Basel II standards, which enables a bank intending t perate glbally t be readily accepted n the internatinal market, prvided that these standards are met. Maximising the Benefits f Basel II Basel II calculates the capital requirement accrding t the bank risk prfile and cntains incentives fr imprvement in risk management within the banking system. By using varius appraches t measure credit risk, market risk and peratinal risk, the result btained is mre risk-sensitive allcatin f bank capital. In Basel II, the calculatin f bank capital is prescribed in Pillar 1 the Minimum Capital Requirement. The alternative appraches can essentially be aggregated int tw majr grups: the standardised mdels that apply t all banks and the mre sphisticated internal mdels develped as apprpriate t the nature f business and risk prfile f the individual bank. A cmparisn between the tw majr appraches reveals that internal mdels can generally be expected t generate mre precise capital adequacy calculatins apprpriate t the risks faced by the bank. This will ffer banks an incentive that is expected t prmte sustained effrts t build the quality f risk management. In this way, ver time, banks will maximise the benefit f the mre sphisticated appraches in calculating their capital requirement. Minimum Capital Rati = 8% = Capital (Tier 1 + Tier 2 + Tier 3) Risk-Weighted Assets Market Risk Credit Risk Operatinal Risk Risk f lss frm n and ff balance sheet psitins frm changes in market factrs (interest rates and exchange rates) Risk f lss frm default by debtrs/ cunterparties Risk f lss directly r indirectly caused by weaknesses r failures in internal prcesses, human resurces and systems and by external events N Significant Changes Significant Changes Additinal Risk 5

6 In assessing bank capital adequacy, it is nt nly necessary t allcate capital n the basis f Pillar 1, but als capital t anticipate lsses frm ther risks, such as liquidity risk, strategic risk, interest rate risk in the banking bk and ther risks. This apprach is captured in Pillar 2, the Supervisry Review Prcess, and is referred t as the Individual Capital Adequacy Assessment Prcess (ICAAP). It will pse an imprtant challenge fr banks and supervisrs. Building f supervisr cmpetence and capacity will be essential, as als the supprt f the regulatry framewrk fr bank supervisin. With time, supervisrs will becme effective in the assessment f risks ther than thse cvered in Pillar 1 and may even rder banks t add t their capital if bank capital is deemed inadequate. Furthermre, the active public rle in scrutiny f banks is seen as crucial. Frm the beginning, the public will als be expected t assess bank risks and ascertain the level f capital adequacy as envisaged in Pillar 3 Market Discipline. The synergy f the three Pillars in Basel II is integral t building a sund and stable banking industry and financial system. Impact f Basel II n the Resilience f the Banking System 1. Will Basel II cause bank CAR t drp belw the 8% minimum? Bank Indnesia is nw wrking tgether with a number f banks n a peridical study f quantitative impact t assess the c nsequences f Basel II n bank capital. Fr this reasn, the impact f Basel II shuld be examined n an individual basis. It is necessary t perfrm assessments and imprve the effectiveness f risk management frm an early stage in rder t gain maximum advantage frm the available incentives. A drp in the CAR culd well ccur fr banks with a higher risk prfile. Hwever, banks whse credit prtflis are dminated by retail lans and hme mrtgages will see a reductin in their capital requirement because f the lwer risk weightings that will apply t retail lans and hme mrtgages. 2. Will Basel II be implemented fr all cmmercial banks? The fcus f Basel II in Indnesia is develpment and imprvement in risk management within the natinal banking system. This was set ut in Bank Indnesia Regulatin N. 5/8/PBI/2003 dated 19 May 2003 cncerning Applicatin f Risk Management fr Cmmercial Banks. These measures will apply t all banks regardless f size, given that the risk management culture shuld becme standard practice in the banking business. Survey shws that banks wuld prefer Basel II t be implemented acrss the bard. The main reasn is t minimise the negative impact n cmpetitin that wuld arise frm differentiatins by ability and readiness f banks t implement and develp risk management and the assciated infrastructure. Furthermre, all banks in Indnesia will be able t apply the standard appraches in Basel II. 3. Culd Basel II hamper the intermediatin prcess? Basel II is nt intended t hamper the intermediatin prcess currently in peratin in the banking system. At the macr level, it als des nt seek t reduce the dminant rle f the banking system in financing ecnmic activities. The verall thrust f the appraches put frward in Basel II is intended mre as an effrt t repsitin and redefine what has been achieved by the banking system, with fcus n imprving risk management. In regard t the intermediary functin, Basel II is nt a mechanical capital regime with n rm fr tlerance. Rm fr flexibility is assured by a number f natinal discretin clauses. While Basel II is expected t see reduced expsures t certain 6

7 sectrs (e.g. because f the use f ratings in lending t crprate entities), n the ther hand it will als encurage increased expsures t ther sectrs, such as retail lending (e.g. small-scale business credit, persnal lans and s n) and husing mrtgages thrugh reduced risk weightings. It is understd that this shift in expsures will bring sme shck t banks, debtrs and the ecnmy as a whle. Even s, this effect is nt expected t last lng, and will be n mre than a fine tuning custmary t any ecnmy. 4. What will be the impact fr banks currently wrking n raising their capital fr the implementatin f the Indnesian Banking Architecture? Raising additinal capital fr the purpses f the Indnesian Banking Architecture will nt in itself prvide the means fr a bank t achieve full cmpliance with Basel II. Hwever, a n adequate capital base will enable a bank t develp the human resurces and infrmatin technlgy capabilities essential fr Basel II. In this way, the Rp 80 billin tier 1 capital requirement fr cmmercial banks, t be met by the end f 2007, and the Rp 100 billin requirement fr the end f 2010 will nt nly expand the ecnmy f scale in cnducting peratins, but als prvide pprtunity fr the bank t strengthen its risk management capabilities fr implementatin f Basel II. 5. What are the prerequisites fr prper implementatin f Basel II? Cnditins that must be satisfied fr prper implementatin f Basel II include: - Applicatin f risk management practices in the banking system as stipulated in Bank Indnesia Regulatin N. 5/8/PBI/2003 dated 19 May 2003 cncerning Applicatin f Risk Management fr Cmmercial Banks - Adjustments in accunting standards in keeping with internatinal accunting standards (IAS), including but nt limited t IAS 32 and IAS 39 - Cnslidated calculatin f bank capital t cver cmpanies in the same grup perating in the financial sectr, with the exceptin f insurance cmpanies - Recgnitin f a rating agency t enable bjective rating f bank debtrs. Radmap fr Basel II in Indnesia: What Bank Indnesia and the Banking System Must D t Prepare Basel II states that each supervisry authrity must weigh pririties befre adpting Basel II. In implementing Basel II, Bank Indnesia is essentially seeking t strengthen risk management s that banks will b ecme mre resistant t dmestic, reginal and internatinal shcks. Bank Indnesia has develped a realistic frmat t be fllwed in the implementatin f Basel II that takes accunt f the current cnditin f the banking industry. Fr this reasn, the default mde fr implementatin will be t take the simplest path, i.e. the standardised apprach. This means that all banks will make adjustments t their capital adequacy calculatins n the basis f the Basel II guidelines. Basel II als prvides fr natinal discretin, in which sme matters are decided by the lcal supervisry authrity. Judgements can therefre be made fr the cnditin f the Indnesian banking system and cmplexity f Indnesia's banking prducts. As part f the nging cnsultatins n the substance f Basel II, including natinal discretin, Bank Indnesia has set up a wrking grup tgether with the banking system t develp recmmendatins n the mst apprpriate regulatry framewrk. These recmmendatins will then be set ut in a Cnsultative Paper (CP) t be distributed t stakehlders and especially banks in rder t invite pinins, suggestins and inputs. 7

8 There have been widespread misunderstandings amng bankers that banks will be required t adpt mre advanced appraches demanding heavier investment in expensive IT and databases, a requirement that wuld bviusly place banks under financial strain. In principle, banks are given flexibility t adpt mre advanced appraches, such as IRB, prvided that the necessary preparatins in IT, human resurces and systems are cmplete and the bank risk prfile ffers assurance that the use f a mre advanced apprach wuld ffer benefits fr the bank. In these cases, banks may apply t Bank Indnesia fr apprval. The BI supervisrs will validate the state f preparedness f the bank befre permitting the bank t calculate capital adequacy using internal mdels. Bank Indnesia is nw prviding special training t bank supervisrs wh will becme validatrs f market risk and validatrs f credit risk. Use f Risk Calculatin Apprach Publish BI Regulatins PILLAR 1 Parallel Run (Standardised) 1) r Validatin Prcess (Internal Mdel) CAR Methd Effective Imprvements t Cmmercial Bank Reprt Online System PILLAR 2 Other Risks 4) Issue BI CAR Methd Regulatins Effective PILLAR 3 Transparency Publish BI Regulatins Q1/2009 Market Risk Standardised 2) Q3/2007 Q1/2008 Q4/2008 Q1/2009 Q4/2008 Q3/2007 Q1/2009 Internal Mdel 3) Q3/2007 Start Q3/2007 Q2/2008 Q2/2008 Q1/2009 Credit Risk Standardised Q3/2007 Q1/2008 Q1/2009 Q1/2009 Q4/2008 Q1/2009 IRBA 3) Q4/2009 Start Q1/2010 Q4/2010 Q4/2010 Q2/2011 Operatinal Risk Basic Indicatr Q3/2007 Q1/2008 Q1/2009 Q1/2009 Q4/2008 Q1/2009 Standardised 3) Q4/2009 Start Q1/2010 Q4/2010 Q4/2010 Q2/2011 AMA 3) Q4/2009 Start Q1/2010 Q2/2011 Q4/2010 Q2/2011 Implementatin f Basel II in Other Cuntries In cntrast t the G-10 cuntries, nn G-10 natins d nt cme under any deadline fr implementatin f Basel II. This is cnsistent with the underlying nature f Basel II, which des nt cnstitute a legally binding dcument impsing sanctins n nncmplying cuntries. Furthermre, assessment f a cuntry s financial sectr stability will nt be based n implementatin f Basel II, but mre n that cuntry s cmpliance with the 25 B asel Cre Principles fr Effective Banking Supervisin (BCP). Fr this purpse, Indnesia has made steady imprvements in cmpliance with the BCP in recent years. Indeed, the sheer diversity f preparatins and plicies means that each cuntry will fllw a unique path in implementing Basel II. The cnditin, structure and business cmplexity f the banking system and quality f bank supervisin are the main factrs that will be taken int accunt in establishing these plicies. In the United States, fr example, the advanced IRB (A-IRB) will be adpted by nly the 10 leading banking grups widely knwn fr their internatinal peratins. Other banks will apply a Basel II frmat knwn as Basel 1A. 8

9 Bank Capital Fr banks, as fr cmpanies in general, capital functins nt nly as the main resurce fr financing peratins, but als prvides a buffer against pssible lsses. Capital als helps t maintain public cnfidence in the ability f a bank t perate in the intermediatin f custmer funds. The bank supervisin authrity is respnsible fr ensuring a minimum adequacy f bank capital by establishing rules cncerning this issue. Regulatry Capital is the capital requirement prescribed by the supervisry authrity as a buffer against ptential lsses. The requirements applying t Regulatry Capital are a key cmpnent f bank supervisin and are reflected in the definitin f regulatry capital and the capital adequacy rati (CAR). Definitin f Regulatry Capital A general definitin f capital was first intrduced in Basel I, the first brad apprach t capital adequacy. This definitin has remained unchanged and is retained in Basel II. The definitin states that regulatry capital is divided int three tiers. An item may be gruped int ne f these tiers, prvided that it satisfies certain criteria. The definitin f regulatry capital sets ut the criteria fr categrisatin as an element f capital, and thus ensures cnsistency f capital adequacy amng different natins. This has prmted mre cmmn understanding amng banks in general and the mre internatinally active banks in particular. Under Basel I and Basel II, regulatry capital is divided int three levels r tiers f capital as fllws: Tier 1 capital. This tier c nsists f instruments with the greatest capacity t absrb lsses arising at any time. Tier 2 capital. This tier cnsists f a brad mix f equity cmpnents and hybrid capital/debt instruments. Ttal Tier 2 capital is restricted t 100% f Tier 1 and is divided int tw categries: Upper Tier 2, restricted t 100% f Tier 1 capital, Lwer Tier 2, restricted t 50% f Tier 1 capital. Tier 3 capital was added in 1996, and is used nly t meet capital requirements fr market risk. The Capital Adequacy Rati (CAR) The bjective f this rati is t ensure that banks are capable f absrbing lsses incurred in the curse f their activities. The existing regulatry rati is the 8% minimum. This links bank capital t the risk weightings f assets held by the bank. Supervisr risk weighting is the percentage used t cnvert the nminal value f credit expsures t a specific value reflecting level f risk. The risk weighting fr each asset is prescribed in a Bank Indnesia regulatin. The capital that must be allcated t cver ptential lss in relatin t the expsures is btained by multiplying the expsure value by the weighting fr the assets and the minimum capital requirement (i.e. 8%). Sme banks have begun using capital adequacy assessment appraches as a risk management functin. Banks will nrmally assess the amunt f capital required t cver lss up t a certain level f prbability. The develpment f these appraches has 9

10 been driven by evidence that capital is a very cstly resurce fr a bank. The bank must therefre have strng incentives t manage capital as effectively as pssible. Since the mid-1990s, sme f the wrld's largest and mst sphisticated institutins have develped varius measures f ecnmic capital and have specifically cmbined these with risk management systems fr mre efficient management f risks and capital. The bjective f bank supervisin is t ensure that banks cnduct their peratins in line with prudent, sund principles. T this end, banks must maintain adequate capital and reserves t ffset risks arising in the curse f business. The main principles f the Basel Cmmittee n Banking Supervisin (BCBS) state that bank supervisrs must establish a safe and apprpriate level f minimum capital requirement fr all banks. The ultimate gal f all authrities invlved in bank supervisin is t prtect the stability and sundness f the financial system. Since the end f 1980, standardised calculatins f bank capital based n the BCBS guidelines have cme int widespread internatinal use in supprt f this gal. Cmpliance with the minimum capital requirement (r slvency rati) is determined by tw cmpnents as fllws: The risk weightings fr bank assets i.e. all bank expsures cnverted int assets with each expsure then multiplied by the supervisr risk weighting, based n level f risk 2 minimum ratis (r limits) in which regulatry capital is linked t asset risk weightings: Regulatry capital divided by risk-weighted assets must be equal t r greater than 8% Tier 1 capital divided by risk-weighted assets must equal at least 4%. 10

11 STRUCTURE OF BASEL II The new capital adequacy framewrk - Basel II - ffers greater flexibility by establishing a number f risk-sensitive appraches and incentives fr imprved risk management. Banks are asked t allcate less capital fr cunterparties with higher ratings and mre capital fr thse with higher risk. The framewrk cnsists f three pillars as fllws: Pillar 1 (Minimum Capital Requirement) deals with the required minimum capital that each bank must prvide t cver credit, market and peratinal expsures. Pillar 2 ( Supervisry Review Prcess) establishes the supervisry review prcess aimed at ensuring an adequate level f bank capital t cver the full scpe f bank risks. Pillar 3 (Market Discipline) addresses market discipline and the specifics f minimum limits f public disclsure. I. Pillar 1 - Minimum Capital Requirement Pillar 1 establishes the minimum capital requirement in relatin t credit risk, market risk and peratinal risk. In Basel II, the required level f bank capital is at least 8% f risk-weighted assets. Within this cntext, capital is divided int several categries: Tier 1 capital, i.e. the mst basic level f capital cnsisting f shares plus nncumulative preferential shares and reserves, subtracted by gdwill. Tier 1 capital must cmprise at least 50 percent f bank capital. Tier 2 capital, cnsisting f asset revaluatin value, general reserves, hybrid capital instruments and subrdinated lans. This tier may nt exceed 50 percent f capital Tier 3 capital, was added in the 1996 Capital Accrd Amendment, but is used nly t cver the prtin f the bank capital requirement allcated t market risk. This categry cnsists f special types f shrt-term subrdinated lans. I.1. Credit Risk Basel II allws a financial institutin t calculate credit risk fr cmpliance with capital regulatins by ne f the fllwing tw methds: Under the Standardised Apprach (SA), the bank uses a list f risk weightings t calculate the credit risk fr its assets. The risk weightings are linked t ratings issued fr the gvernment, financial institutins and cmpanies by an external rating agency. The Internal Rating Based Apprach (IRB) allws banks t use their wn internal mdels fr cunterparties and expsures. This allws fr mre specific differentiatin f risk amng varius expsures, prducing a level f capital mre cmmensurate t risk. Credit Risk Standardised Apprach (SA) Under this apprach, the bank allcates certain risk weightings fr each categry f assets and ff-balance sheet items t arrive at a ttal figure fr risk-weighted assets as fllws: Risk-Weighted Assets = Ttal expsures x risk weighting 11

12 Allcatins fr each risk weighting are based n general debtr categries (gvernment, bank r crprate), which subsequently classified further accrding t ratings issued by an external credit rating agency. The standardised apprach prescribes risk weightings based n differences in the nature f the assets and external credit ratings t prduce a mre risk-sensitive result in cmparisn t the current Accrd. The risk weightings fr the gvernment, ther banks and crprate expsures are differentiated accrding t the external credit ratings. A 100 percent risk weighting prduces a capital charge at 8% f the expsure value. Similarly, a 20% risk weighting prduces an equivalent capital charge f 1.6% (20% x 8%). Other risk weightings have als been established accrding t differences in the nature f expsure. Examples f risk weightings fr these categries in use are: - 35% fr expsures t residential husing cmplying with strict prudential criteria; - 75% fr retail expsures (lans t small and medium enterprises meeting certain criteria enabling them t be treated as retail businesses); - 100% fr expsures t cmmercial prperties, with limited exemptins under certain cnditins; - 150% fr high risk expsures, such as lans past due; and - 350% fr securitised cmpnents rated BB+ and BB-. Credit Risk Internal Rating Based Apprach (IRB) The IRB apprach recgnises that banks are custmarily better infrmed f their debtrs than a rating agency. This apprach enables a bank t apply mre precise differentiatins fr each risk in cmparisn t the seven risk categries (0%, 20%, 35%, 50%, 75%, 100% and 150%) in the standardised apprach. There are tw appraches used in the IRB, bth f which are based n strict measurement standards and methdlgy and require supervisr apprval: - Fundatin IRB the bank calculates prbability f default (PD) fr each debtr and the supervisr prvides ther input, such as lss given default (LGD) and expsure at default (EAD). - Advanced IRB in additin t PD, the bank includes ther inputs such as EAD, LGD and maturity (M). Stricter requirements apply fr using this apprach in cmparisn t fundatin IRB. Majr parameters in the IRB apprach: - Prbability f Default is the likelihd that a debtr will default n bligatins. All banks must prvide an internal mdel f PD fr each debtr categry. - Lss Given Default (LGD) is the estimated percentage f lss that wuld ccur in the event f a debtr's default. - Expsure at Default (EAD) is the estimated expsure t a particular debtr in the event f default. - Maturity (M) is the effective tenr (in years) f a bank expsure. Asset Categries in the IRB Apprach - Crprate Expsures debt liabilities wed by cmpanies r arising frm partnerships r wnership. This categry is divided int five sub-assets: prject financing, purchase financing, cmmdity financing, incme-generating real estate and high vlatility cmmercial real estate. - Bank Expsures expsures t banks and securities cmpanies. 12

13 - Gvernment Expsures expsures t the gvernment, the central bank, public sectr entities and MDBs. - Retail Expsures retail lans including lans t individuals and small-scale businesses, credit card peratins, wrking capital lans, hme mrtgages and fixed instalment lans. Basel II identifies tw sub-categries: expsures guaranteed by residential prperty and retail expsures meeting certain qualificatins, including ther retail credit. - Equity Expsures wnership interests in cmpanies, partnerships and ther crprate business. Incentives The capital rules are designed t encurage banks t shift frm the standardised apprach t the IRB and frm Fundatin IRB t Advanced IRB. By switching t a mre advanced apprach, many banks will benefit frm reduced capital allcatin under the capital rules as a result f the mre accurate linkage between capital and risk. Nevertheless, the pssibility remains that bank prtflis are n average higher risk and the IRB apprach demands a higher standard than the standardised apprach. Mitigatin f Credit Risk A lender can mitigate credit risk if a debtr prvides cllateral r a third party underwrites the debtr s bligatins r the bank buys credit prtectin, fr example thrugh credit derivatives, r by ther means. Cmpared t the Accrd 88, Basel II prvides fr brader recgnitin f credit risk mitigatin techniques. Basel II allws banks t recgnise the fllwing frms f cllateral: - Cash - Designated securities issued by the gvernment, public sectr entities, banks, cmpanies and securities cmpanies - Designated negtiable equities - Designated mutual funds - Gld Fr banks using the standardised apprach t calculate credit risk, Basel II ffers tw pssible methds fr credit risk mitigatin: - The simple apprach, which enables g uaranteed claims t be assigned a risk weighting against the cllateral instrument, subject t a minimum limit f 20%. - The cmprehensive apprach, fcused n the cash value f cllateral. This apprach uses the haircut t calculate vlatility f cllateral value. This may be the standard haircut as determined by the Basel Cmmittee r an estimate f cllateral vlatility prepared by the bank. If a bank is apprved fr use f an internal mdel, the ptins f the simple appraches described abve are nt available. In the case f banks using the IRB apprach, the LGD cmpnent is als adjusted t reflect the benefit f using cllateral t reduce lsses. Asset Securitisatin Securitisatin is a technique emplyed by banks t transfer risk while raising liquidity. Traditinally, bank assets are pled and then sld by issuing securities guaranteed by that pl f assets. In Basel II, banks must use the securitisatin framewrk in 13

14 calculating their capital requirements against expsures arising frm traditinal securitisatin and syntheses r similar structures with these features. Because f the many different methds f securitisatin, the determinatin f the capital required t cver securitisatin expsures must be based n ecnmics substance ver frm. The same principle als applies t supervisrs, wh must give greater emphasis t ecnmics substance in determining whether the expsure fit within the securitisatin framewrk fr calculating bank capital adequacy. In securitisatin, the bank may act as the riginal creditr r investr fr the securitised assets. In either f the tw categries, the bank rle can vary widely. Whatever the frm, Basel II stresses that banks must allcate capital t cver varius frms f securitisatin. I.2. Market Risk On 1 January 1998, banks in the G -10 cuntries were required t allcate capital t cver market risk (as stipulated in the market risk amendment t the Basel Accrd). The bank capital requirement fr market risk is determined by tw methds. The first is the standardised apprach, which applies a building blck apprach fr interest rate and equity instrument-related transactins. This apprach differentiates between calculatin f capital charges fr specific risks and general market risk. The secnd is the internal mdel apprach, which enables banks t use internal methds cmplying with the qualitative and quantitative criteria determined by the Basel Cmmittee, subject t apprval frm the supervisry authrity. This apprach sets capital charges at a higher level than the previus day's VaR r the average daily VaR fr 60 wrking days multiplied by three minimum factrs. Banks must calculate the VaR n the basis f daily value with - ne-tailed cnfidence interval f 99% - 10-day minimum hlding perid - ne-year minimum bservatin perid. The internal mdel used by the bank must accurately cver certain risks related t ptins and ptin-like instruments. 14

15 I.3. Operatinal Risk The Basel Cmmittee defines peratinal risk as the risk that riginates directly r indirectly frm inability r failure f internal prcesses, persns and systems, as well as frm external events." Three appraches may be used t determine the capital charges fr peratinal risk: The Basic Indicatr Apprach calculates capital charges fr peratinal risks n the basis f a certain percentage (alpha factr) f grss incme used as an estimate fr bank risk expsures. Under this apprach, the capital that must be allcated by the bank t cver lsses arising frm peratinal risks equals a certain percentage f average grss incme ver a three year perid. The Standardised Apprach requires an institutin t disaggregate its activities int eight standard business lines. The capital charge fr each business line is calculated by multiplying its grss incme by a certain predetermined cnstant (beta factr) that is different fr each business line. In the Advanced Measurement Apprach, the calculatin f the capital requirement is the same as the risk measurement generated by a mdel fr measuring peratinal risk develped i nternally by the bank. The bank must meet the qualitative and quantitative criteria stipulated in Basel II and must have apprval frm the supervisry authrity. Calculatin f Capital Adequacy Basel II requires banks t allcate capital at 8% f risk-weighted assets, calculated accrding t the fllwing frmula: Fr example, a bank has USD10 billin in risk-weighted assets, a USD300 millin capital charge fr market risk and a USD100 millin capital charge fr peratinal risk. The minimum capital requirement fr the bank is: = [USD10 billin x (USD300 millin + USD100 millin)] x 8% = USD1.2 billin This means that the bank must allcate capital f at least USD1.2 billin. II. Pillar 2 - The Supervisry Review Prcess Pillar 2 fcuses n the review prcess within the supervisry framewrk that is aimed at ensuring that banks maintain levels f capital cmmensurate t their risk prfile. The supervisry review prcess seeks t ensure that banks calculate their capital adequacy t cver the full scpe f risk and supervisrs assess and take any necessary actins t respnd t the capital calculatins made by the bank. The supervisr may ask the bank t set aside capital in excess f the minimum capital rati r take remedial measures such as strengthening f risk management r ther actins. If a higher r ati becmes necessary, the supervisr may intervene if bank capital is belw that limit. 15

16 Pillar 2 requires banks t cnduct regular stress testing t estimate hw much capital wuld be required under crisis cnditins. The bank and the supervisr must use the test results t ensure that bank capital is at an adequate level. Pillar 2 encmpasses fur key principles: Banks must have a prcess fr calculating verall capital adequacy based n their risk prfile and a strategy fr maintaining their level f capital; The supervisr must review and evaluate the strategy and capital adequacy calculatins made internally by the bank and the ability f the bank t mnitr and ensure cmpliance with the prescribed capital rati; The supervisr may rder a financial institutin t perate abve the prescribed capital rati and has the authrity t rder a bank t allcate capital abve the minimum limit; and The supervisr may intervene at an early stage t prevent decline in bank capital belw the minimum limit and t ensure that the bank takes remedial measures if the level f capital is nt maintained r sinks t its frmer level. III. Pillar 3: Market Disclsure Pillar 3 requires banks t disclse adequate infrmatin fr market players t understand the risks invlved in the banks. This enables market players t assess the key infrmatin n the scpe f risk, capital, risk expsures, risk measurement prcess and bank capital adequacy. In sme cases, disclsure serves as a special criteria in Pillar 1 enabling the bank t apply a lwer risk weighting and/r use a particular methdlgy. This is expected t perate as a frm f direct sanctin because f failure t cmply with the disclsure requirements (e.g., nt permitted t apply lwer risk weightings r use certain methdlgies). Pillar 3 als discusses the issues f the rle f significant infrmatin, frequency f disclsure and issues regarding prprietary infrmatin. 16

17 Frequently Asked Questins 1. What is BIS? The Bank fr Internatinal Settlements (BIS) is an internatinal rganisatin that prmtes internatinal mnetary and financial cperatin and perates as the bank fr central banks. T meet its respnsibilities, BIS carries ut a number f key activities. As a frum fr prmting discussins and plicy analyses amng central banks and within the internatinal financial system. As a research centre fr ecnmics and mnetary plicy As a leading partner fr central banks in financial transactins As an agent r representative fr central bank dealings in internatinal financial activities. 2. What is the Basel Cmmittee n Banking Supervisin? The Basel Cmmittee n Banking Supervisin (BCBS), better knwn as the Basel Cmmittee, was established in a vluntary actin by the mnetary authrities f the G- 10 cuntries and a number f ther natins. The cmmittee has n fficial reach as an internatinal supervisry authrity and its decisins are never intended t be legally binding. The Basel Cmmittee was set up by central bank gvernrs frm the G-10 cuntries at the end f 1974 and cnvenes fur times a year. These cuntries are represented by their central banks and als the authrities respnsible fr supervisin f the banking business if nt under the pwers f the central bank. The Cmmittee develps plicy guidelines that natinal supervisry authrities may decide n as apprpriate t the supervisry plicy t be implemented by the individual cuntry. The Basel Cmmittee frmulates supervisin standards and guidelines gf a eneral nature and issues statements with brad applicatin n best practices. This is intended t enable each authrity t take measures fr applying these standards within a legal and regulatry framewrk apprpriate t the individual cuntry s system. The mst imprtant utput f the Basel Cmmittee is the ruling n minimum capital standards fr banks wrldwide. The Basel Capital Accrd was first annunced in July 1988 and was implemented by all members f the Basel Cmmittee in Althugh the accrd was initially targeted at internatinally active banks, it ultimately gained brad internatinal acceptance amng banks and supervisry authrities. Mre than 100 cuntries arund the wrld have nw adpted the Basel Accrd. 3. What are the differences between Basel I and Basel II? Basel II builds n the basic structure f the 1998 accrd (Basel I) t determine capital requirements in relatin t credit and market risk and t develp a mre risk-sensitive capital framewrk. This has been achieved by adjusting capital requirements t credit risk and als by intrducing changes in the methd fr calculating capital t cver expsures frm risk f lsses attributable t peratinal failures. Even s, in brad terms the Basel Cmmittee has retained the aggregate level f the minimum capital requirement and establishes incentives fr applicatin f the mre advanced risk-sensitive appraches within the Basel II framewrk. Basel II cmbines the minimum capital requirement with supervisry review and market discipline t prmte imprvement in risk management. 17

18 4. What are the bjectives f the Basel Capital Accrds? The bjectives f Basel I and Basel II are essentially the same. First, the Basel I framewrk was designed t imprve sundness and stability f the internatinal banking system. Secndly, the Basel I framewrk was expected t create a level playing field amng different cuntries with a high level f cnsistency in perceptins t reduce surces f unfair cmpetitin amng internatinally active banks. In the Basel II framewrk, the Cmmittee believes that the changes t the existing appraches will encurage the banking industry t use the imprved risk management methds. 5. Is it cmpulsry fr a natin t implement Basel II? N cuntry is required t implement Basel II. N plicy issued by BIS is legally binding n any cuntry. Fr this reasn, implementatin f Basel II is a decisin at the individual cuntry level, taking int accunt the state f preparedness f that cuntry's banking system. 6. What impact des Basel II have n a natin? When a cuntry implements Basel II, this actin is expected t strengthen financial system stability by prmting advancement in risk management and capital adequacy in the banking system. Furthermre, Basel II is als expected t: Imprve crprate gvernance and risk management Create mre efficient capital allcatin and build a rbust capital structure Strengthen standards f transparency Imprve bank supervisin in regard t prcesses and implementatin. 7. Can Basel II be implemented in Indnesia? Yes. Basel II is a brad plicy framewrk cnsisting f a set f best practices applied wrldwide. The cncepts in Basel II can therefre be applied in any cuntry, including Indnesia. 8. Why must Basel II be implemented in Indnesia? Basel II prescribes a mre risk-sensitive framewrk fr calculatin f the capital requirement. These capital adequacy calculatins als take int accunt the varius risks invlved n a mre cmprehensive scale. This will encurage banks t imprve their risk management in rder t btain a mre precise value f ecnmic capital. It will als encurage supervisrs and market players t play a greater rle in financial system stability. 9. Is it apprpriate fr Indnesia t implement Basel in the near future? Yes. Since the intrductin f Basel I, the Indnesian banking system has undergne far reaching changes frm: Glbalisatin Develpments in technlgy Innvatins in the financial wrld Furthermre, Basel I fcuses nly n credit risk and market risk, thereby simplifying assumptins f risks in a way that will nt prtect bank sundness. Basel II prvides a framewrk capable f maintaining the sundness and stability f the banking system thrugh: Strengthening f internal prcesses Prmting the use f mre advanced and sphisticated risk management practices Risk measurements mre accurately depicting the true level f risks carried by the bank Imprvements in transparency. 18

19 10. What apprach will be used in Indnesia? Bank I ndnesia will intrduce the standardised, internal rating-based and advanced appraches. These appraches will be phased in ver time. The decisin n the apprach t be used will be made by individual banks with apprval frm the supervisr. 11. May banks chse the apprach they use? Yes, banks may chse the apprach they wish t use. Hwever, the use f any apprach ther than the standardised apprach must be apprved by the bank supervisr. If a bank has already used the internal rating based r advanced apprach, it will nt be permitted t replace the apprach in use with the standardised apprach withut apprval frm the bank supervisr. 12. Will banks be required t use the Internal Rating-Based r Advanced apprach? N, banks are nt required t use either the internal rating-based r the advanced apprach. The decisin abut which apprach t use is entirely at the discretin f the individual bank. If a bank is unable t implement an internal rating-based r advanced apprach, it will be encuraged t remain with the standardised apprach. 19

20 GLOSSARY - Pillar 1: Rules establishing a minimum rati f capital t risk-weighted assets. - Pillar 2: The supervisry review pillar, requiring supervisrs t perfrm a qualitative review f the capital allcatin techniques used by the bank and cmpliance with relevant standards. - Pillar 3: Disclsure requirements that facilitate market discipline. - Internal Rating: Result f a bank s risk measurement f its credit prtfli. - External Credit Rating: Rating issued by an external rating agency. - Cnslidatin: Measurement f bank risk encmpassing the entire business grup linked t the bank. - Operatinal Risk: Risk arising directly r indirectly frm the inability r failure f internal prcesses, persns r system r frm external events. - Credit Risk: Risk f lss arising frm default by a debtr r cunterparty. - Market Risk: Risk f lss arising frm a trading psitin when prices underg change. - Mitigatin f Credit Risk: A set f techniques enabling a bank t prtect part f its psitin frm cunterparty default (fr example, by taking ver cllateral r encashing a guarantee r purchasing hedging instruments). - Asset Securitisatin: Aggregatin f assets r liabilities int securities fr sale t third parties. 20