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The Basel II Capital Accord

The Basel II Capital Accord

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The Basel II Capital Accord

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  1. The Basel II Capital Accord June 2005

  2. Chapter 1 – Basel basics Executive Summary 7 Basel I overview 8 Basel II overview Timing 9 Scope of application 10 Capital components 13 Types of Banks 14 IRB Transition Period 16 Chapter 2 – Basel II minimum capital charges – First Pillar Sovereign exposures 18 Bank exposures 21 Corporate exposures 24 Retail exposures 27 Real estate exposures 30 Covered bonds 33 Specialised lending 34 Table of Contents Source: Text

  3. Chapter 2 – Basel II capital charges (cont’d) Off-balance sheet items 35 Equity 37 Non-performing loans 39 Credit risk mitigation (CRM) 45 Securitisation exposures Standardised banks Ratings based approach 51 Most senior exposures; second loss positions or better 52 Liquidity facilities 53 Overlapping exposures 55 IRB banks Ratings based approach 57 Internal assessments approach 58 Supervisory formula approach 61 Liquidity facilities 63 Top-down approach 64 Table of Contents (cont’d) Source: Text

  4. Chapter 2 – Basel II capital charges (cont’d) Early amortisation structures 66 Trading book 71 Chapter 3 – Basel II operational risk charges 84 Basic indicator approach Standardised approach Advanced measurement approach Chapter 4 – Supervisory Review – Second Pillar Four key principals of supervisory review 87 Supervisory review process for securitisation 89 Table of Contents (cont’d) Source: Text

  5. Chapter 5 – Market discipline – Third Pillar Qualitative disclosure 92 Quantitative disclosure 93 Chapter 6 – Some observations Open issues 95 Impact on financial markets 96 Impact on banks 97 Impact on securitisation markets 98 Impact on ABCP conduits 99 Contact Details 100 Table of Contents (cont’d) Source: Text

  6. Chapter 1Basel II Basics

  7. Executive Summary • Basel II introduced to: • combat regulatory arbitrage • exploit and improve bank risk management systems Basel I • In effect since 1988; very simple in application • Easy to achieve significant capital reduction with little or no risk transfer • Will profoundly alter bank behaviour Basel II • Much more complex and risk sensitive • First Pillar – Minimum capital • Second Pillar – Supervisory review • Third Pillar – Market discipline • Treats exposures very unequally depending on exposure characteristics • Treats banks very unequally depending on sophistication of risk management systems Source: Text

  8. Basel I – Capital Charges • Risk weights • OECD sovereigns: 0% • OECD banks: 20% • Residential mortgages: 50% • Synthetic: 20% super-senior, 0% cash-collateralised mezzanine, deduction or100% first loss (with national variations) • Unfunded commitments under one year: 0% • Unfunded commitments over one year: 50% • Everything else: 100% • Sample capital calculation • €100 million corporate exposure • 100% risk weight = €100 million risk weighted assets (RWA) • Capital charge = Capital = 8% minimum RWA • Capital charge: €8 million Source: Text

  9. Basel II Published June 2004 End 2006 for standardised and foundation IRB banks (¶ 2) End 2007 for advanced IRB banks (¶ 2) End 2009 (at earliest) before full IRB benefits achievable due to transition period (¶¶ 45-49) Basel/IOSCO review (not yet final) will change CRM rules and rules for trading book exposures Capital Requirements Directive (CRD) Will implement Basel II within EU Same adoption timing sought May vary from Basel II (and thus from rules in US and elsewhere) in important respects However New rules will alter banks’ behaviour right away Some countries will adopt prior to expected implementation dates, at least in part Implementation may be delayed in some countries Reaction of US regulators to QIS 4 results may cause delays EU and member state adoption schedules not usually so quick Implementation may not be uniform 140+ items subject to national discretion Supervisory discretion Lengthy adoption time permits lobbying Basel II – Timing Unless otherwise indicated, all references to paragraph numbers in these materials refer to paragraphs in June 2004 Basel II Accord Source: Text

  10. Applied on consolidated basis to internationally active banks (¶ 20)* All banking and other financial activities (whether or not regulated) captured through consolidation (¶ 24) Financial activities do not include insurance (¶ 24, fn. 5) Majority-owned subsidiaries not consolidated: deduct equity and capital investments (¶ 27) Significant minority investments without control: deduct equity and capital investments (¶ 28) Deduction of investments 50% from tier 1 and 50% from tier 2 capital (¶ 37) Insurance entities Generally, deduct bank’s equity and other capital investments in insurance subsidiaries (¶ 30) However, some G10 countries will retain current risk weighting treatment (100% for standardised banks) for competitiveness reasons (¶ 31) Supervisors may permit recognition by bank of excess capital invested in insurance subsidiary over required amount (¶ 33) Commercial entities generally deducted significant investments in commercial entities above materiality thresholds (¶ 35) Significant investments in commercial entities below materiality thresholds risk weighted 100% (¶ 36) Basel II – Scope of Application * EU rules (CRD) will also apply to solo entities and to investment firms Source: Text

  11. Definition of regulatory capital unchanged (¶ 41) (but some changes anticipated going forward) Treatment of provisions Standardised approach: general provisions can be included in tier 2 capital up to limit of 1.25% of risk-weighted assets (¶ 42) IRB approach: Securitisation and certain equity exposures: expected loss (EL) amount must first be deducted from capital (¶ 43) Other exposures: bank must compare total eligible provisions against total EL amount and deduct any excess EL amount over eligible provisions (excess of provisions over EL amount may be added to tier 2 capital up to maximum of 0.6% of risk-weighted assets (¶ 43, ¶¶ 374-386) Scaling Factor Scaling factor of 1.06 (subject to recalibration following QIS 4 and QIS 5) introduced to ensure same aggregate amount of capital remains in banking system following Basel II adoption (¶ 44, fn. 11) Basel II – Capital and Provisions Source: Text

  12. Basel II – Three Pillars Minimum Capital Charges: Minimum capital requirements based on market, credit and operational risk to (a) reduce risk of failure by cushioning against losses and (b) provide continuing access to financial markets to meet liquidity needs, and (c) provide incentives for prudent risk management (¶¶ 40-718) First Pillar Supervisory Review: Qualitative supervision by regulators of internal bank risk control and capital assessment process(¶¶ 719-807), including supervisory power to require banks to hold more capital than required under the First Pillar Second Pillar Market Discipline: New public disclosure requirements to compel improved bank risk management (¶¶ 808-822) Third Pillar

  13. Basel II – Capital Components • Credit risk charges (¶¶ 40-643) • Revised • To ensure capital charges are more sensitive to risks of exposures in banking book • Enhancements to counterparty risk charges also applicable to trading book exposures • Operational risk charges (¶¶ 644-683) • New • To require capital for operating risks (fraud, legal, documentation, etc.) • Market risk charges (¶¶ 684-718) • Initially unchanged, but Basel/IOSCO review has proposed changes to specific risk calculations and Second Pillar stress testing • To require capital for exposures in trading book • Rules in Market Risk Amendment (1996) Source: Text

  14. Basel II – Types of Banks Standardised • Measure credit risk pursuant to fixed risk weights based on external credit assessments (ratings) • Least sophisticated capital calculations; generally highest capital burdens • Most Japanese banks will start Basel II as standardised banks • Most US banks will stay under Basel I (or, more likely, will move to Basel 1½) • Measure credit risk using sophisticated formulas using internally determined inputs of probability of default (PD) and inputs fixed by regulators of loss given default (LGD), exposure at default (EAD) and maturity (M). • More risk sensitive capital requirements • Most European banks will likely qualify for Foundation IRB status at start of Basel II Foundation IRB Advanced IRB • Measure credit risk using sophisticated formulas and internally determined inputs of PD, LGD, EAD and M • Most risk-sensitive (although not always lowest) capital requirements • Transition to Advanced IRB status only with robust internal risk management systems and data • Top 10 US banks expected to implement Advanced IRB at start of Basel II Under Basel II, banks have strong incentive to move to IRB status and reduce capital charges by improving risk management systems

  15. External Ratings Criteria External credit assessment institution (ECAI)(rating agency) recognised/ approved by national supervisor on basis of objectivity, independence, transparency, disclosure, resources and credibility (¶ 91) Recognition If two assessments, higher risk weight applied (¶ 97) If three or more assessments, two lowest risk weights referred to and higher of those two applied(¶ 98) Multiple ratings Ratings assessment must take into account entire exposure (principal only ratings will not qualify) (¶ 100) Assessment Credit risk mitigation (CRM) not recognised if taken into account in rating (¶ 101) CRM Subject to national discretion, unsolicited ratings recognised (¶ 108) Solicited Source: Text

  16. Transition Period (IRB Banks only) 2007 Foundation IRB capital requirements for credit risk, operational risk and market risk may not fall below 95% of the current minimum required for credit and market risks (¶ 46) 2008 IRB capital requirements for credit risk, operational risk and market risk may not fall below 90% of the current minimum required for credit and market risks (¶ 46) IRB capital requirements for credit risk, operational risk and market risk may not fall below 80% of the current minimum required for credit and market risks (¶ 46) 2009 2010 and after BIS Committee and/or national supervisors may extend floor if warranted (¶ 48) Source: Text

  17. Chapter 2Basel II – First PillarMinimum Capital Charges

  18. Losers • OECD rated below AA- • Examples: Czech Republic, Greece, Hungary, Mexico, Turkey • Winners • non-OECD rated above BB+ • Examples: Chile, China, Thailand Basel II – Sovereign Capital Charges Sovereigns – In a Nutshell Basel I Basel II Rating A2/BBB+ Baa3/BBB- B1/BB- Ba1/BBB- A1/A- A1/A- Standardised bank risk weights Sample est. FIRB bank risk weights* Type of Sovereign Risk Weight 0% 20% 50% 100% 150% 100% 25% 68% 141% 100% 24% 24% Poland Russia Turkey Bulgaria Czech Republic Hungary AA- or above OECD 0% A non-OECD 100% BBB External Rating Country BB+ to B- below B- unrated * Inputs: average rating agency values for PD, LGD of 45%, supervisory value for EAD and M of 2.5. (Moody’s rating applied if different from S&P) Source: Text

  19. Basel II – Sovereign Capital Charges Sovereigns – Standardised Banks (¶¶ 53-59) • Risk weights for sovereign exposures: • Risk weights may also be based on ECA risk scores • Claims on non-central government public sector entities based on corporate exposure risk weights • Claims on multilateral development banks have 0% risk weight if conditions are met, including: (i) majority of MDB’s ratings are AAA, (ii) significant portion of shareholders are AA- or better rated sovereigns, (iii) funding is in form of paid-in equity with little or no leverage, and (iv) conservative lending criteria • At national discretion, lower risk weight for banks’ exposures to their sovereign (or central bank) in domestic currency; if adopted, other regulators may permit same risk weight Source: Text

  20. Basel II – Sovereign Capital Charges Sovereigns – IRB Banks (¶¶ 270-272) • Formula for exposure not in default: Correlation (R) = 0.12 × (1 – EXP (-50 × PD)) / (1 – EXP (-50)) + 0.24 × [1 - (1 - EXP(-50 × PD))/(1 - EXP(-50))] Maturity adjustment (b) = (0.11852 – 0.05478 × ln (PD))^2 Capital requirement (K) = [LGD × N [(1 - R)^-0.5 × G (PD) + (R / (1 - R))^0.5 × G (0.999)] – PD x LGD] x (1 - 1.5 x b)^ -1 × (1 + (M - 2.5) × b) Risk-weighted assets (RWA) = K x 12.5 x EAD • Capital requirement for defaulted exposure equals greater of zero and difference between exposure’s LGD and bank’s best estimate of loss • Input characteristics (applicable to all types of exposures) (¶¶ 285-325): • PD: internally determined one-year probability of default • LGD: • FIRB: 45% (senior)/75% (subordinated); adjusted (LGD* = LGD x (E* / E) for CRM recognition • AIRB: own estimates; adjusted for CRM recognition • EAD: not less than sum of (a) amount by which bank capital would reduce if exposure written-off fully and (b) specific provisions and partial write-offs • M: 2.5 years for FIRB (6 months for repos); own est. for AIRB for each exposure; max. 5 years Source: Text

  21. Basel II – Bank Capital Charges Banks – In a Nutshell Basel I Basel II Type of Bank Risk Weight Standardised Option 1 Standardised Option 2 FIRB est. risk weights* 20% 50% 100% 100% 150% 100% 20% 50% 50% 100% 150% 50% 14% - 24% 24% - 28% 38% - 68% 100% - 197% 226% NA OECD AA- or above AA- or above 20% non-OECD A+ to A- A+ to A- 100% BBB+ to BBB- BBB+ to BBB- External Rating External Rating BB+ to B- BB+ to B- below B- below B- unrated Unrated*** * Using inputs of average rating agency values for PD, LGD of 45%, supervisory value for EAD and M of 2.5. • Winners • non-OECD rated above BB+ under Option 2 • Examples: May Bank, Public Bank Berhad • Losers • OECD rated A or below under either option • Examples: Commerzbank, HVB, SEB, Mizuho, Bradesco ** Using inputs of rating agency values for PD, LGD of 10%, supervisory value for EAD and M of 2.5. *** Internal PD estimate to be applied. Source: Text

  22. Basel II – Bank Capital Charges Banks – Standardised Banks (¶¶ 60-65) 2 options, selected by national regulator to apply for all banks in jurisdiction: • Option 1: Banks risk weighted one category below risk weights of banks’ sovereigns: • Option 2: At national discretion, banks risk weighted on basis of own external ratings (plus more favourable risk weight if claim maturity < 3 months) • Local currency reduction: National regulators may reduce by one notch risk weight of local currency bank debt having maturity of less than 3 months, subject to floor of 20% • Exposures to securities firms treated as bank claims if regulatory arrangements comparable Source: Text

  23. Basel II – Bank Capital Charges Banks – IRB Banks (¶¶ 270-272) • Formulas for bank exposures same as for sovereign exposures, but with floor for PD of 0.03% • Effective floor of 16 to 48 basis points for highest quality credits (depending on maturity assumption) under Advanced IRB • Generally, PD for high-quality bank debt will be below 0.03% floor (so floor must be used) • More realistic 10% LGD for Advanced IRB bank (rather than 45% supervisor-imposed LGD for Foundation IRB banks) results in significant capital reductions • Compare to 56 basis point floor for highest quality ABS Source: Text

  24. Losers • Corporates rated below BB- • Winners • Corporates rated above BBB+ Basel II – Corporate Capital Charges Corporates – In a Nutshell Basel I Basel II Risk Weight Standardised Option 1 Standardised Option 2 FIRB est. risk weights* 100% 20% 50% 100% 150% 100% 100% 100% 100% 100% 100% 14% - 24% 24% - 28% 38% - 68% 100% - 197% 226% NA AA- or above AA- or above A A External Rating BBB+ to BB- BBB External Rating below BB- BB+ to B- unrated below B- Unrated** * Using inputs of rating agency values for PD, LGD of 45%, supervisory value for EAD and M of 2.5. ** Internal PD estimate to be applied. Source: Text

  25. Basel II – Corporate Capital Charges Corporates – Standardised Banks (¶¶ 66-68) 2 options, selected by national regulator to apply for all banks in jurisdiction: • Option 1: Corporates risk weighted as set out in following chart (supervisory authority to increase 100% risk weight for unrated corporates where warranted by higher default rates): • Option 2: At national discretion, all corporates risk weighted at 100% without regard to external ratings • SME Adjustment: 75% risk weight for unrated SME if exposure under €1 million and either treated by bank as retail or guaranteed by individual • Includes claims on insurance companies Source: Text

  26. Basel II – Corporate Capital Charges Corporates – IRB Banks (¶¶ 270-274) • Formulas for corporate exposures same as for bank exposures, including floor for PD of 0.03% • SME Adjustment for firms setting total annual sales (S) at €50 million or and €5 million or more: • Subject to national discretion, supervisors may allow banks to substitute total assets for total sales • SME adjustment generates approx. 20% reduction in risk weights (depending upon original creditworthiness) • Effective floor of 14% risk weighting for foundation IRB banks due to minimum PD of 0.03% representing a capital charge of 112 bps Correlation (R) = 0.12 × (1 – EXP (-50 × PD)) / (1 – EXP (-50)) + 0.24 × [1 - (1 - EXP(-50 × PD))/(1 - EXP(-50))] – 0.04 × (1 – (S-5)/45) Source: Text

  27. Default Generally From 150% to 50% depending on level of specific provisions against exposure 75% if conditions met • Internally determined PDs and LGDs under Foundation IRB Basel II – Retail Capital Charges Retail – In a Nutshell Basel I Basel II Standardised bank risk weights Risk Weight FIRB est. risk weights* 100% 70% - 110%** 60% - 90%*** Credit cards Other Retail * PD and LGD inputs provided by bank (¶ 331); PD floor at 0.03% ** Using PD of 3% and LGD of 80% and PD of 5% and LGD of 90%, respectively *** Using PD of 5% and LGDs of 40% and 60%, respectively Source: Text

  28. Basel II – Retail Capital Charges Retail – Standardised Banks (¶¶ 69-71) • Generally • 75% risk weight if: • Exposure to individual or small business • Exposure takes form of revolving credit, line of credit, personal loan, lease, or small business facility (mortgage loan excluded to extent otherwise covered (see below)) • Portfolio diversified (granular); Basel II accord suggests no aggregate exposure to any one counterparty should exceed 0.2% of overall portfolio • Maximum aggregate counterparty exposure €1 million or less • Effective floor of 600 basis points • Past Due • Unsecured portion of exposure past due for more than 90 days, net of specific provisions, risk weighted as follows: • 150% when specific provisions less than 20% of outstanding amount of exposure • 100% when specific provisions 20% or more of outstanding amount of exposure • 100% when the specific provisions 50% or more of outstanding amount of exposure, with supervisory discretion to reduce risk weight to 50% in such case Source: Text

  29. Basel II – Retail Capital Charges Retail – IRB Banks (¶¶ 326-338) • Formula for qualifying revolving retail exposure not in default: Correlation (R) = 0.04 Capital requirement (K) = LGD × N[(1 - R)^-0.5 × G(PD) + (R / (1 - R))^0.5 × G (0.999)] – PD × LGD Risk-weighted assets (RWA) = K x 12.5 x EAD • Formula for other retail exposure not in default: Correlation (R) = 0.03 × (1 – EXP (-35 × PD)) / (1 – EXP (-35)) + 0.16 × [1 - (1 - EXP(-35 × PD))/(1 - EXP(-35))] Capital requirement (K) = LGD × N[(1 - R)^-0.5 × G(PD) + (R / (1 - R))^0.5 × G (0.999)] – PD × LGD Risk-weighted assets (RWA) = K x 12.5 x EAD • When only drawn balances securitised, bank must hold required capital against unfunded commitment Source: Text

  30. * Subject to conditions ** Reduced 50% risk weight possible, subject to conditions Basel II – Real Estate Capital Charges Real Estate – In a Nutshell Basel I Basel II Standardised bank risk weights Type of Exposure Risk Weight FIRB est. risk weights 10% - 50%*** 20% - 90%**** Residential Residential 35%* Residential 50% Commercial Commercial Commercial 100%** 100% *** Using PD of 1% and LGD of 10% and PD of 2% and LGD of 25% **** Using PD range of 0.07% and 2.1% and LGD of 35% Source: Text

  31. Basel II – Real Estate Capital Charges Real Estate – Standardised Banks • Residential Real Estate (¶¶ 72-73) • 35% risk weight for exposures fully secured by mortgages on residential property occupied by the borrower or rented • Strict prudential criteria (including loan to value ratios) determined by national regulators • Supervisors may require increased risk weight if data warrant • Effective floor of 280 basis points • Commercial Real Estate (¶ 74) • Generally 100% risk weight, given experience in numerous countries with troubled credits over the past few decades • However, 50% risk weight possible in certain markets if (among other conditions): (i) tranche not greater than lower of 50% of market value and 60% of mortgage lending value, (ii) losses on tranche do not exceed 0.3% in any year, and (iii) overall losses from commercial real estate in relevant market do not exceed 0.5% in any year Source: Text

  32. Basel II – Real Estate Capital Charges Real Estate – IRB Banks • Residential Mortgages – Formula for exposure not in default (¶¶ 327-328): Correlation (R) = 0.15 Capital requirement (K) = LGD × N[(1 - R)^-0.5 × G(PD) + (R / (1 - R))^0.5 × G (0.999)] – PD × LGD Risk-weighted assets (RWA) = K x 12.5 x EAD • High volatility commercial real estate (HVCRE) (¶¶ 280-284): • At national discretion, banks may assign preferential risk weights of 70% to “strong” and 95% to “good” where maturity is less than 2.5 years or supervisor determines bank’s underwriting criteria and other risk characteristics are substantially stronger • Treated differently under CRD Source: Text

  33. Basel II – Covered Bonds Capital Charges Covered Bonds – In a Nutshell Basel I (CRD) Basel II (CRD) Type of Exposure EU Risk Weight FIRB est. risk weights*** Standardised bank risk weights 4% 10% Senior debt RW UCITS qualifying 20%* 50%** 100% 150% PD of 0.03% 10% Covered bond RW PD of 0.15% Exceptions* 10% 20% 50% 100% 20% * Requires rating of AAA to AA- * Italy, Portugal, Sweden, UK *** LGD of 12.5% required in CRD with PD floor of 0.03%. Using inputs PD as noted, LGD of 12.5%, supervisory value for EAD and M of 2.5. ** Requires rating of A+ to A- under Option 1 and rating of A+ to BBB- under Option 2 Source: Text

  34. Basel II – Specialised Lending Capital Charges Specialised Lending – In a Nutshell Basel I Basel II IRB bank risk weights (¶¶ 275-284) Standardised bank risk weights (¶ 80) Risk Weight All All 100% 100% Five Classes of Specialised Lending: • Project finance • Object finance • Commodities finance • Income-producing real estate • High-volatility commercial real estate Generally: For exposures other than HVCRE, banks that do not meet requirements for estimation of PD will map internal grades to five supervisory categories (70% for strong, 90% for good, 115% for satisfactory, 250% for weak and 0% for default) (¶ 275) At national discretion, supervisors may allow 50% for “strong” and 70% for “good” if remaining maturity less than 2.5 years or supervisor determines underwriting or other risk characteristics are substantially stronger (¶ 277) Source: Text

  35. Basel II – Off Balance Sheet Items Off Balance Sheet Items – Standardised Banks (¶¶ 82-89) • Off-balance sheet items converted into credit exposure equivalents using credit conversion factor (CCF) • Commitments • Original maturity of up to one year: 20% CCF • Original maturity in excess of one year: 50% CCF • Unconditionally cancelable: 0% CCF • Securities lending • Lending of bank securities or posting as collateral (including repo and reverse repo transactions): 100% CCF • Letters of Credit • Short-term self-liquidating trade letters of credit: 20% CCF • Other commitments • As specified in Basel I • Failed transactions • As specified by national regulators • Effect of failed transactions on off-balance sheet items subject to Basel/IOSCO review Source: Text

  36. Basel II – Off Balance Sheet Items Off Balance Sheet Items – IRB Banks (¶¶ 310-316) • Off-balance sheet items converted into exposure at default (EAD) input using credit conversion factor (CCF) under either foundation approach to EAD or advanced approach to EAD: • Foundation approach to EAD • Types of instruments and CCFs same as for standardised approach (¶¶ 82-89) except for commitments, note issuance facilities (NIFs) and revolving underwriting facilities (RUFs) • CCF of 75% applicable to commitments, NIFs and RUFs regardless of maturity • CCF of 0% if commitment unconditionally cancelable • Advanced approach to EAD • Banks allowed to use own estimates of CCF if allowed to use internal estimates for EAD (¶¶ 474-478) • But 100% CCF if required under foundation approach to EAD Source: Text

  37. Basel II – Equity Capital Charges Equity – In a Nutshell Basel I Basel II† Rating A3/BBB Aa3/AA- Ba1/BB+ Aaa/AAA A1/A Baa3/BBB- Baa1/BBB+ Standardised bank risk weights Type of Exposure Risk Weight Simple Model* PD/LGD Model** Corporates Non-consol equity 100%* 100% DaimlerChrysler Siemens Fresenius Med. Care GE Sony Vivendi Universal Bertlesmann 290% 290% 290% 290% 290% 290% 290% 92%*** 81%*** 264% 32%*** 82%*** 195%*** 120%*** Banks 100% Securities firms 100% Company † For banking book exposures.National supervisors may exempt from IRB treatment for up to ten years particular equity exposures held at publication date of Basel II accord (¶ 267) ** Inputs: average rating agency PDs, LGD of 90%, supervisory value for EAD and M of 5. * CRD has preferential treatment vs. Basel II Accord; supervisors may increase to 150% for venture capital and private equity investments (¶ 80) *** Under Basel II (¶ 353) a floor risk weight of 200% applies to listed equities Source: Text

  38. Basel II – Equity Capital Charges IRB Banks – Three Approaches • Simple risk method (¶¶ 344-345) • CRD: 190% risk weight for diversified private equity exposures (not in Basel II) • CRD: 290% risk weight for publicly traded exposures (300% in Basel II) • CRD: 370% risk weight for all other holdings (400% in Basel II) • Internal models method (¶¶ 346-349) • Taken from VaR models as 12.5 times difference between • 99% percentile one-tail quarterly return and • Risk free rate over long-term sample period • Floor: capital charge under simple risk model but using 200% (traded) and 300% (not traded) • PD/LGD method under CRD (¶¶ 350-361) • Generally, use normal corporate exposure formulas if possible (results in risk weights substantially below 200% and 300% floor in Basel II) • If bank does not have sufficient information to use definition of default, then apply scaling factor of 1.5 to risk weights • Unfunded credit protection on equity exposure recognised, subject to LGD of 90%, with reduced LGD of 65% for private equity exposures Source: Text

  39. Basel II – Non-Performing Loan Capital Charges Non-Performing Loans (NPLs) – In a Nutshell Basel II/CRD Basel I IRB bank risk weights Standardised bank risk weights (¶¶ 75-78) • No uniform rules: • In Europe – combination of general and specific provisions • In US five-tier ranking system derives capital Generally: Unsecured portion of exposure past due for more than 90 days, net of specific provisions, risk weighted as follows: • 150% when specific provisions less than 20% of outstanding amount of exposure • 100% when specific provisions 20% or more of outstanding amount of exposure • 100% when specific provisions 50% or more of outstanding amount of exposure, with supervisory discretion to reduce risk weight to 50% in such case Residential Mortgages: risk weighted at 100% net of specific provisions; at national discretion risk weight reduced to 50% of specific provisions 20% or greater Commercial Mortgages: unexpected loss risk-weighted at 100% Generally: capital requirement for defaulted exposure is equal to greater of zero and difference between LGD (described in para. 468) and bank’s best estimate of expected loss (¶ 272) Under IRB approach, for asset classes other than securitisation, bank must compare (i) total amount of eligible provisions with (ii) total expected losses and deduct excess (if any) of expected losses over provisions (¶ 43, ¶¶ 380-383) For securitisation exposures or the PD/LGD approach for equity exposures, bank must first deduct EL amounts under paras. 563 and 386, respectively (¶ 43) Source: Text

  40. Basel II – Non-Performing Loan Capital Charges Non-performing loans – Generally • Essentials: • Non-performing loan under Basel II is any loan that is past due for more than 90 days, but subject to national variation • For purposes of defining secured portion of non-performing loan, eligible collateral and guarantees will be recognised as under CRM rules for performing loans • Capital charges depend on level of specific provisions held against loan

  41. Basel II – Non-Performing Loan Capital Charges Non-performing loans – Standardised Approach • Unsecured non-performing loan: • Unsecured portion of non performing loan will be risk-weighted as follows: • 150% when specific provisions less than 20% of outstanding amount of exposure • 100% when specific provisions 20% or more of outstanding amount of exposure • 100% when specific provisions 50% or more of outstanding amount of exposure, with supervisory discretion to reduce risk weight to 50% in such case • Secured non-performing loan: • Qualifying residential mortgage loans risk weighted at 100%, net of specific provisions. If such loans are past due but specific provisions are no less than 20% of their outstanding amount, the risk weight applicable to the remainder of the loan can be reduced to 50% at national discretion • Commercial mortgages: unexpected loss risk weighted at 100% • Non-performing loans fully secured by forms of collateral not recognized under Basel II (eligible financial collateral) risk weighted at 100% when provisions reach 15% of outstanding amount of loan

  42. Basel II – Non-Performing Loan Capital Charges Non-performing loans – IRB Approach • General Rules: • Capital charges to cover unexpected losses • Bank must cover expected losses with specific provisions • Consequences: • Fixed LGD at 45% for non-retail assets and senior exposures may result in risk weights as follows: • 565% when no specific provisions of outstanding amount of exposures • 400% when specific provisions 20% of outstanding amount of exposure • 0% when the specific provisions 50% or more of outstanding amount of exposure

  43. Basel II – Non-Performing Loan Capital Charges Non-performing loans – sample capital calculation (€100 million NPL) Assumptions: • Supervisory discretion allows use of 50% risk weight if exposure has specific provision of 50% or better • LGD in Advanced IRB Approach is 30% • IRB Approach and Advanced IRB Approach are approximated

  44. Basel II – Non-Performing Loan Capital Charges Non-performing loans – Originator´s point of view and market outlook • Motivations to sell non-performing loan portfolios: • Reduce capital supporting non-performing loans • Reduce negative carry by eliminating financing needs • Shift capital and resources into more profitable businesses • Optimize bank’s balance sheet • Improve bank’s credit ratings • Reduce operating costs due to smaller work-out departments • Market outlook • Basel II will motivate banks to sell NPLs • German NPL market estimated between €160 billion and €300 billion (Boersenzeitung 18.2.2005) • German NPL market development to increase to estimated €20 billion this year and possible average of €15 billion per year after 2007 (Boersenzeitung 18.2.2005) • No capital charges required if investors not banks

  45. Basel II – Credit Risk Mitigation Credit Risk Mitigation (CRM) – In a Nutshell Basel I Basel II Type of Exposure Risk Weight* IRB banks Standardised banks OECD sovereign 0% Simple approach: Risk weight of CRM is substituted for risk weight of unsupported exposure Comprehensive approach: Adjust value of both amount of exposure and value of CRM with either supervisory or own-estimate “haircuts”; adjust for maturity and currency mismatches Generally: CRM reduces PD or LGD inputs OECD bank 20% 20% Non-OECD bank** * Same as simple approach under Basel II for standardised banks (i.e., substitution) † Subject to considerable change due to Basel/IOSCO review, including introduction of “double default” recognition for certain exposures rather than substitution approach ** Maturity of < one year Source: Text

  46. Basel II – Credit Risk Mitigation Credit Risk Mitigation – General Rules (¶¶ 109-210) Determine capital as provided on following page, except determine capital pursuant to securitisation rules (following) if credit risk protection tranched (e.g., purchased derivatives) Protection Buyer Protection Seller Treat as cash position in underlying • First to default and second to default protection (¶¶ 207-210) • Proportional cover (¶ 190(c), ¶ 198)) • Maturity and currency mismatches: size of haircut depends on type of instrument, type of transaction and frequency of mark-to-market and remargining (¶ 135) Specific Adjustments

  47. Basel II – Credit Risk Mitigation Credit Risk Mitigation – Capital Calculation Method Simple Approach (¶ 129, ¶¶182-185) • Risk weight of CRM substituted for risk weight of unsupported exposure (¶ 129) • Subject to floor of 20%, with exceptions, e.g., core market participant floor is 0%, subject to certain conditions (¶ 183) Comprehensive Approach (¶¶ 130-138) • Supervisory or own-estimate haircuts adjust both amount of exposure and value of collateral received (¶ 130) • Further adjustments for maturity mismatches (square root of time formula) and currency mismatches (¶ 135) Guarantees and credit derivatives recognised; only limited double-default recognition proposed under Basel/IOSCO review (¶¶140-142, ¶¶189-193) VaR models permitted subject to supervisory approval (¶ 138, ¶¶ 178-181) On-balance sheet netting recognised (¶ 139, ¶ 188) Standardised Banks IRB Banks Generally • Collateral reduces PD or LGD input (reducing required capital) (¶¶ 289-307) Guarantees and credit derivatives recognised; only limited double-default recognition proposed under Basel/IOSCO review (¶ 301) VaR models permitted subject to supervisory approval (¶ 292) On-balance sheet netting recognised (¶ 292)

  48. Basel II – Credit Risk Mitigation Credit Risk Mitigation - Eligible Financial Collateral • Cash and gold • Rated debt securities (sovereign BB- or higher; other BBB- or higher) • Senior, unrated debt securities issued by bank if listed on recognised exchange and all other bank issues are BBB- or higher • Equities included in main index or listed on recognised exchange • UCITS/mutual funds where price quoted daily and UCITS/fund only invests in above instruments • For IRB banks only: receivables, real estate and other collateral meeting minimum requirements (¶ 289) • All items recognised as collateral in banking book can also be recognised in trading book Eligible Collateral (¶¶ 145-146) No correlation Collateral must not have material positive correlation with underlying exposure (¶ 124) First-to-Default Second-to-Default • First-to-default: recognised if bank obtains protection for entire basket, credit event triggers contract, and notional of underlying less than contract (¶¶ 207-208); regulatory capital relief for asset with lowest risk-weight in the basket • Second-to-default: recognised if bank obtains first-to-default protection as above or if one asset already defaulted (¶¶ 209-210)

  49. Basel II – Credit Risk Mitigation Credit Risk Mitigation - Other Criteria • Recognition of credit derivatives (¶¶ 191-194) • Legally binding documentation; direct claim on provider; irrevocable and unconditional • Mandatory credit events not determined solely by protection provider: (a) failure to pay, (b) insolvency and (c) Restructuring (recognition up to 60% of underlying if no restructuring) • If asset mismatch, underlying/reference obligation must be pari passu and protection must contain cross-default/cross-acceleration • Cash settlement permitted if robust valuation process • If protection purchaser’s right to transfer underlying subject to obligor consent, may not be unreasonably withheld • Eligible protection providers (¶ 195) • Sovereigns, public sector entities, and banks and securities firms with lower risk weighting than underlying exposure (not SPEs) • Counterparty risk charges for OTC derivatives (¶¶ 186-187) • Counterparty credit risk charge = [(RC + add-on) – CA] x r x 8% where: RC=replacement cost; add-on= as determined under Basel I; CA=volatility adjusted collateral amount; r=risk weight of counterparty • Being changed to model-based approach under Basel/IOSCO review Source: Text

  50. Basel II – Securitisation Capital Charges Securitisation – In a Nutshell Basel I Basel II Standardised banks IRB banks Type of Exposure Risk Weight 100% • Risk weights based on rating of position. If exposure unrated, then deduct from capital except in case of: • Most senior exposure (look-through to average risk weight of pool) • Second loss position or better(look-through to higher of 100% and highest risk weight of pool) • Liquidity facilities (credit conversion factors depending on type and length of liquidity commitment) Generally • Hierarchy of approach: • If exposure rated must determine risk weight based on ratings based approach (RBA) • If unrated exposure to ABCP conduit may use internal assessments approach (IAA) if conditions met • If unrated exposure may use supervisory formula approach (SFA) if can determine inputs (including using top down methodology) • If unrated exposure and RBA, IAA and SFA unavailable, may use exceptional “look through” approach with regulator consent on temporary basis for liquidity facilities • Otherwise, must deduct unrated exposure from capital First loss Deduct Unfunded < one year 0% Source: Text