The International Standard of Banking Regulations with Basel II

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Basel II is the international standard that banking regulators use when creating regulations on how much capital banks need to put aside to guard against financial and operational risks being faced. The Basel II's main aim is to introduce a more comprehensive and risk-sensitive treatment of banking risks to ensure that regulatory capital bears a closer relationship to credit and other risk.(Source: Introduction to Banking by Barbara Casu,page 173). Meanwhile, to comply with the Basel II, banks need to implement credit rating techniques that represent the risk profile of their particular credit portfolios. The Internal Rating Based Approach (IRBA) of Basel II allows banks to use their own models for estimation of risk parameters. There are 3 key Basel II risk parameters: The Likelihood of a default by the counterparty-Probability of Default (PD). The absolute losses value under default- Exposure at Default (EAD). The share of the losses under the counterparty's default-Loss given Default (LGD). http://www.scorto.com/basel_2.htm The Basel II framework has faced intense criticism for the collapse of Lehman brothers, because large banks (Lehman brothers) were permitted to build capital adequacy framework, with minimal supervision from banking regulators. Credit risk for banks consists of the amounts owed by borrowers on loans for both interest payments and loan principal repayments, and also for customers' debts on other transactions, such as swaps, letters of credit, performance bonds or forward rate agreements (FRAs). Lending is the principal business activity for most commercial banks. The loan portfolio is typically the largest asset and the predominate source of revenue. As such, it is one of the greatest sources of risk to a bank's safety and soundness. Whether due to lax credit standards, poor portfolio risk management, or weakness in the economy, loan portfolio problems have historically been the major cause of bank losses and failures. http://www.occ.treas.gov/handbook/lpm.pdf A bank as a financial institution that lends money to its customers is subject to a lot of risk and by so doing has to manage the risk of lending portfolios of which the banks are required to calculate the PD(Probability of default) ,EAD(Exposure at default) as well as LGD(Loss given default). The Probability of default (PD) is also known as the expected default frequency, which is derived from moody's analytics. It is the likelihood that a loan will not be repaid and will fall into default that is three (3) missed payments in 12 months. There are various methods of estimating the PD, usually it is derived from a historical data base of actual defaults using techniques like logistic regression, credit defaults swaps, bonds or option on common stock through the use of external rating agencies such as Fitch, moody's and standard and poor. Exposure at default (EAD): This is a measure used in the calculation of economic capital or regulatory capital under Basel II for a banking institution.EAD is seen as an estimation of the extent to which a bank is exposed to a counterparty in the event of and at the time of the counterparty's default. http://bis2information.org/content/Exposure_At_Default_EAD Simply the EAD means the total value that a bank is exposed to at the time of default. Each underlying exposure that a bank has is given an EAD value and is identified within the banks internal system. http://www.investopedia.com/terms/e/exposure_at_default.asp Example For retail bank exposures, any change of a facility (e.g. extending the life of a mortgage to reduce monthly payments) is regarded as a default. Also, loss Given Default (LGD): This is the actual total loss that is experienced by a bank when a debtor defaults on a loan from that bank. The loss given default is not always equal to the total amount of the loan. Example, if the debtor pledged collateral against the loan, the bank could receive these assets, and their total loss would not be greater than the amount of the loan minus the value of the assets. http://www.investorwords.com/6858/loss_given_default.html Loss Given Default (LGD) is the magnitude of likely loss on the exposure and is expressed as a percentage of the exposure.LGD is determined in two ways: Foundation methodology: here the LGD is based upon the characteristics of the underlying transaction where the starting point proposed by the Committee is use of a 50% LGD value for most unsecured transaction. And for transactions with qualifying financial collateral, the LGD is scaled to the degree to which the transaction is secured. Advanced methodology: here the bank itself determines the appropriate Loss Given Default to be applied to each exposure, on the basis of robust data and analysis which is capable of being validated both internally and by supervisors. http://www.basel-ii-risk.com/Basel-II/Basel-II-Glossary/Loss-Given-Default.htm Basel II requires that, at a minimum, banks subject their credit portfolios in the banking book to stress tests. Stress testing empowers customers to attain compliance with Basel II requirements for retail credit risk management while improving reserve capital and credit portfolio management efficiency. http://www.scorto.com/basel_2.htm Banks use stress testing (which is a critical tool used) as part of their internal risk management and capital planning. The guidance sets out a comprehensive set of principles for the sound governance, design and implementation of stress testing programmes at banks. The principles address the weaknesses in such programmes that were highlighted by the financial crisis. Also, Stress testing also is a key component of the supervisory assessment process that assists supervisors in identifying vulnerabilities and evaluate banks' capital adequacy. The principles therefore establish expectations for the role and responsibilities of supervisors when evaluating firms' stress testing practices. http://www.bis.org/publ/bcbs155.htm Banks use stress testing because it gives a clear view of how a portfolio could be affected by unexpected events. http://findarticles.com/p/articles/mi_m0ITW/is_8_84/ai_n14897105/ Uses of Stress Testing Stress testing enables a bank to see how well it would be able to withstand the situations of expected losses, provisions, ratio of criticised loans to the whole book, ratio of nonperforming loans to provisions or the whole book. http://findarticles.com/p/articles/mi_m0ITW/is_8_84/ai_n14897105/ Preparing for contingencies: Through the critical review of all information of things that could happen if a given situation were to occur, by preparing for such a loss the experience of the loss will be limited. Stress test also enables the bank to see how well it would be able to withstand situations such as expected losses, provisions, ratio of criticised loans to the whole book, ratio of nonperforming loans to provisions or the whole book, economic capital. Definition of Basel II terms <http://www.foreignbanks.org.uk/Members/simmons/simmons_and_sim... www.foreignbanks.org.uk/Members/simmons/simmons_and_simmons_jargon_buster_for_baselII.doc> There are various information's a lender needs, to access and use in order to assess and manage the risks of lending to its debtors (either to an individual consumer or a company). In the case of lending to an individual consumer, the lender can monitor the consumer's behaviour by observing the ability of the consumer to manage his debts responsibly, to determine how risky it is to lend him money,i.e they want to know how creditworthy the individual is and to know this they need vital information on the individual which can be obtained from the credit application and credit bureau report. Assessing the risks of lending to an individual boils down to the creditworthiness of the individual which is based on the five "C"s of credit, which are: Character or Credit reputation: Basically, this is to know if the borrower will pay back or not, how trustworthy is the borrower? Is the borrower the type that pays back debts as agreed and promptly? How the borrower handles financial obligation especially during periods of adversity is a significant indicator of character or credit reputation. Capacity: This pertains to the borrower's ability to make payment on time, it is determined by weighing the borrowers income (including the likelihood of continued earnings ability) against the amount of debt owed.i.e does the borrower have the capacity to repay the debt? Does he work and does he earn enough to pay back what he owes? Capital: Though capital is not expected to be a means of payment, however it is used as a measure of assurance that debts will be paid if a period of adversity arises.i.e. What assets or financial resources stand behind the borrower commitment to repay a debt? Savings in the bank or a property in the name of the borrower? Conditions: In assessing economic conditions, the lender looks at both national and local forecasts, such as inflation and unemployment that could affect the borrower's ability to repay. Collateral: This is a property or asset of value which the lender can take and sell in case of default ,by following legally mandated procedures(Note: only in the case of a secured loan is a collateral required). Other information a lender should have about an individual consumer is: the age, sex, financial health, income, length of credit history, payment history, outstanding debt and pursuit of new credit of the individual consumer. To asses and manage the risks of lending to a company, the lender should have information on the company's credit rating, credit reports
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