Continued progress toward Basel II

15 January 2004

Press release

The Basel Committee on Banking Supervision continues to make progress on its work to revise the international accord on bank capital following the agenda established in Madrid last October. At today's meeting in Basel, the Committee reviewed the progress made on outstanding matters to meet its mid-year 2004 objective and took decisions on key issues.

Public comments supported the Committee's proposal on credit-related losses

The Committee received 52 comment letters from institutions and industry associations on its October 2003 proposal to revise the capital treatment for expected and unexpected credit losses. Respondents generally welcomed the Committee's solution and agreed that it will align regulatory capital more closely with the concepts underpinning leading banks' economic capital modelling processes. The Committee believes that these comments will be instrumental in strengthening the quality of the New Accord.

The Committee has decided on concrete modifications necessary to implement the proposal made in October and will publish them shortly. Moreover, the Committee agreed with industry comments that the cap on the recognition of excess provisions should not be based on Tier 2 capital components. Instead, it has decided to convert the cap to a percentage (to be determined) of credit risk-weighted assets.

Significant progress achieved on the treatment of securitisation exposures

The Committee agreed to simplify the treatment of securitisation-related exposures and align it more closely to industry practice in response to public comments to the third consultative paper (CP3) on the New Accord. Under the new treatment, banks will be allowed to derive the risk weights on unrated exposures to asset-backed commercial paper conduits (mainly liquidity facilities) by mapping their internal risk assessments to external credit ratings; a less complex "Supervisory Formula" will be available for determining capital for unrated securitisation exposures; and both originating and investing banks will be able to make equivalent use of the "Ratings-Based Approach" (RBA) for rated securitisation exposures. Finally, the Committee reviewed the calibration of the securitisation RBA risk weights to ensure a closer alignment with the level of risk inherent in the positions.

The main points are set out in Attachment A. The Committee will also publish shortly a more detailed technical note specifying the revisions to the securitisation proposals.

Furthermore, progress was made in the following areas.

Advances on credit risk mitigation techniques and related issues

The Committee has agreed to refine the rules for recognising credit risk mitigation techniques in response to industry comments. The Committee likewise recognises that the existing treatment of credit risk mitigation must continue to evolve in order to reflect industry practices, particularly as they relate to double default effects. The Committee believes that recognition of these effects is necessary, though it is essential to consider all of the implications, especially those related to measurement, before a solution is decided. The Committee will continue work on this topic with the intention of finding a prudentially sound solution as promptly as possible prior to implementation of the New Accord.

Alongside this work, the Committee plans to undertake a review of counterparty credit risk and trading book issues in coordination with the International Organisation of Securities Commissions (IOSCO).

Pillar 2 implementation clarified

In response to recent discussions with banking organisations, the Committee agreed on clarifications for implementing the supervisory review of capital, or Pillar 2 of the New Accord. These clarifications are appended as Attachment B.

Cooperation between home and host supervisors

Building on the principles published in August 2003 (High-Level Principles for the Cross-border Implementation of the New Basel Capital Accord), the Accord Implementation Group (AIG) of the Committee is evaluating several actual case studies. This exercise is contributing significantly to member authorities' understanding on practical aspects of cross-border implementation.

The Committee agreed on principles for the cross-border implementation of the advanced measurement approaches (AMA) for operational risk requirements. These principles balance the need for the adequate capitalisation and sound risk management of significant internationally active entities in cross-border banking groups with the need for the practical application of the AMA within these groups. The details of the proposal and related principles will be published shortly.

Schedule

Working groups will make recommendations on the outstanding issues at the Committee's next meeting in May 2004, where the Committee will additionally address the calibration of capital requirements. Both efforts will allow the Committee to achieve its mid-year 2004 goal and ensure that the text will provide a solid basis for national implementation processes and the industry's preparations to proceed. In accordance with the decisions announced in its October 2003 press release, the Committee will again evaluate the New Accord's calibration prior to implementation.

The Committee reaffirmed its objective to maintain broadly the aggregate level of regulatory capital in the banking system. It intends for the simpler approaches to produce overall capital requirements that are broadly equivalent to those of the existing rules while establishing incentives to adopt the more advanced approaches. The Committee will moreover continue to work to ensure that the Accord remains up to date with the best practices in risk measurement and management.

Attachment A

Summary of decisions related to the securitisation framework

Based on comments put forth by the industry in response to CP3, the Committee has made several modifications to the internal ratings-based (IRB) approach to securitisation exposures. The changes follow the decisions of the Committee at its October 2003 meeting in Madrid to address industry concerns raised during consultations related to complexity of the securitisation proposal and potential operational burden related to its implementation. Additionally, industry comments focused on the need for greater internal consistency among the proposals comprising the securitisation framework. A more complete discussion of the Committee's considerations and its proposed revisions to the securitisation framework will be made public shortly.

Treatment of unrated exposures

The Supervisory Formula (SF) described in CP3 was developed to address unrated exposures including those to asset-backed commercial paper (ABCP) conduits. Initial industry reactions to the SF focused on its complexity and associated computational burden. Furthermore, industry participants questioned the consistency of the SF with banks' current risk management practices. After evaluating these comments and conducting additional analysis of its own, the Committee is introducing the following alternatives in lieu of the SF approach contained in CP3, as well as modifications to the calculation of KIRB, which is the capital charge that would have applied had the assets not been securitised.

1. Introduction of an internal assessments approach

The Committee is introducing an internal assessment approach (IAA) for determining capital charges against liquidity facilities and credit enhancements that banks (including third-party banks) extend to ABCP conduits. The IAA would be applicable only to exposures to ABCP conduits that have an internal rating equivalent of investment-grade at inception. It would not be available beyond this limited scope. The IAA will simplify the treatment of banks' exposures to ABCP conduits by aligning regulatory capital requirements more closely to banks' internal risk management practices for such exposures. Subject to a set of operational standards, banks would derive their internal assessments of such exposures based on rating agency criteria for the asset type purchased by the conduit, including those criteria pertaining to the amount of seller-provided credit enhancement needed to achieve a given rating equivalent. The notional amount of the exposure would then be assigned the risk weight corresponding to the external rating equivalent under the Ratings-Based Approach (RBA).

2. Simplification of the Supervisory Formula

In addition to introducing the IAA, the Committee is proposing a simplification to the SF presented in CP3 to be made available to all unrated exposures including liquidity facilities and credit enhancements extended to ABCP conduits. The Simplified SF is based on four bank-supplied inputs: (1) the capital charge that would be applied had the assets not been securitised (KIRB, which, as in CP3, will continue to be defined as the sum of expected and unexpected losses); (2) the degree of credit enhancement supporting a given position (L); (3) the thickness of the exposure in question (T); and (4) the effective number of exposures in the securitised pool (N). In contrast to the SF discussed in CP3, the simplified version would not result in different capital requirements in cases where two pools may have the same KIRB, but different exposure-weighted average LGDs. Accordingly, this eliminates that average as an input to the Simplified SF. In addition, the Simplified SF would be computationally less complex than the formula provided in CP3. It will be elaborated on in the forthcoming technical paper on revisions to the securitisation framework.

Since the publication of the Committee's October 2003 press release regarding its plans to replace the SF with a simpler approach, the Committee has heard from some industry representatives that they would not favour its replacement. The Committee is interested in learning whether such views are widespread.

3. Modifications to Top-Down Approach for calculating KIRB

Market participants raised concerns about their ability to calculate KIRB, an input to all variants of the SF, for securitisation exposures subject to the "top-down" IRB approach outlined in CP3. Banks have indicated that it would be difficult for them to decompose in a reliable manner their expected loss estimates into PD and LGD components. As a result, they would be required under CP3 to assign a LGD of 100% to such exposures. Combined with a conservative treatment of dilution risk, the capital charge associated with the top-down approach was considered to be unduly harsh by the industry.

The Committee is now planning to develop less restrictive operational criteria for allowing banks to rely on their own LGD estimates for securitisation exposures, particularly for exposures to ABCP conduits. The Committee has asked its Securitisation Group to develop more flexible criteria that are broadly consistent with those for the IAA where appropriate. The Committee also recognises that requiring capital for both dilution risk and default risk may represent the double counting of risk. It is working to resolve this issue. These simplifications should help to ensure that banks are able to calculate KIRB for a large number of positions and help to avoid the need for banks to apply more conservative supervisory assumptions to some exposures when determining the capital requirement under the SF.

Consistency within the Securitisation Framework

The Committee has sought to address concerns expressed about the need for greater consistency within the securitisation framework.

1. Simplified SF

The Simplified SF is based on more conservative assumptions than those underlying the formula presented in CP3 in order to bring the analytical models underlying the SF and RBA into closer alignment. As noted above, the Committee recognises the interest of some market participants to retain the original SF. If the original formula were retained, this would by extension raise questions about the need to make modifications similar to those incorporated into the simplified SF to ensure consistency. One such change could involve reductions in the so-called tau parameter found in the formula presented in CP3.

2. Treat originating and investing banks in a similar manner

Additionally, the Committee decided to enhance consistency within the IRB securitisation framework by eliminating differences in the treatment of securitisation exposures held by originators and investors. In CP3, originating banks were required to deduct all positions (whether externally rated or unrated) that fell below the KIRB threshold. Under the change adopted by the Committee, originators would be permitted to recognise external ratings through the equivalent of BB- on positions that fall below the KIRB boundary. The treatment may also be referred to as an "external rating override". The cap on an originating bank's maximum capital requirement will remain in place.

As noted, the change described above is meant to respond to comments made by the industry that the risk associated with a given position is not dependent upon the holder of such a position. In making this change, the Committee reaffirms the importance of external ratings as a market signal of the inherent risk of a given securitisation exposure when a position is externally rated or subject to the IAA. The Committee views the change as an important simplification to the IRB securitisation framework.

Treatment of Rated Securitisation Exposures

In response to industry views, the Committee agreed on changes to the RBA to better align those risk weights with the level of risk inherent in securitisation exposures. As noted in CP3, the RBA applies to externally rated positions as well as those where an inferred rating would apply; as a result of the changes, the RBA would also be used for mapping internal assessments under the IAA to capital charges.

1. Greater focus on seniority

The first change is to shift the focus of the exposures eligible for the lowest set of risk weights (found in the left most column of the RBA risk weight tables in CP3) away from the concept of "thickness" toward "seniority." Commenters have noted that by expanding the eligibility for the preferential risk weights to senior tranches, the RBA framework could be simplified with little or no loss of risk sensitivity. Analyses conducted by the Committee confirm this result. In consequence, this change being made by the Committee would make the lower set of risk weights available to a broader array of exposures.

2. Enhance sensitivity to risk of well-rated exposures

In addition to redefining the definition for applying the column of lower RBA risk weights, the Committee is further differentiating some of the preferential risk weights, as noted below in bold text.

Alternative RBA Risk Weights

External Rating
(Illustrative)

Risk weights for
senior tranches
& eligible IAA

   Base risk   
   weights   

Risk weights for
tranches backed by
non-granular pools

Aaa

7%

12%

20%

Aa

8%

15%

25%

A1

10%

18%

35%

A2

12%

20%

A3

20%

35%

Baa1

35%

50%

50%

Baa2

60%

75%

75%

Baa3

100%

100%

100%

Ba1

250%

250%

250%

Ba2

425%

425%

425%

Ba3

650%

650%

650%

Below Ba3 and unrated

Deduction

Deduction

Deduction

The Committee also considered the industry request to differentiate RBA risk weights by asset type. After further additional review, it does not believe that such a change would result in a material improvement in risk sensitivity.

Additional Considerations

The Committee recognises that by its very nature securitisation relates to the transfer of ownership and/or risks associated with the credit exposures of a bank to other parties. In this respect, securitisation is important in helping to provide better risk diversification and to enhance financial stability. The securitisation framework and its capital impact for originating banks are premised on the expectation that securitisation is used to transfer significant levels of credit risk. Supervisors are considering ways to monitor securitisation transactions to ensure that this is the case. As noted in CP3, supervisors will evaluate transactions based on their economic substance as part of their review process to ensure that the capital treatment for securitisation transactions is applied appropriately.

Attachment B

Current sense of the Committee on the implementation of the supervisory review process - Pillar 2

Pillar 2 of the New Basel Accord recognises the important role that supervisors play in the maintenance of adequate bank capitalisation. Given differences in legal and regulatory structures, the Basel Committee is conscious of the need to maintain adequate flexibility in the application of Pillar 2 in different jurisdictions. As such the Committee has resisted providing extensive prescriptive guidance in this area. Instead, the Committee emphasises the need for a combination of information-sharing on supervisory practices between supervisors on the one hand and constructive dialogue between banks and supervisors on the other to help promote consistency in the implementation of Pillar 2. However, members of the Committee continue to receive comments from the industry that appear to reflect misconceptions about what Pillar 2 means, such as the view that Pillar 2 is moving toward a system of automatic capital add-ons driven less by the circumstances of each bank and more by general regulatory requirements. The Committee would like to clarify its current thinking on the following points.

The Committee's view in creating Pillar 2 was to promote and support a more rigorous process at internationally active banks to determine the actual capital held and to make this process subject to a more focused supervisory review than may have been the case. Pillar 2, both in its first principle and in the consideration of several more specific risks, makes it clear that the prime responsibility is on banks to make this assessment, taking account of their circumstances. In many cases where specific risks are identified under Pillar 2, such as interest rate risk or credit concentration risk, CP3 makes clear that the onus is on banks to take account of these risks in their own capital adequacy assessments and provides high-level guidance on aspects that banks should consider. Pillar 2 then puts the onus on supervisors to satisfy themselves as to the appropriateness of banks' approaches and the adequacy of banks' capital and to take various actions in light of any concerns that supervisors may have.

While there are linkages between Pillar 1 and 2, the Committee sees clear differences between the two. The Committee has been well aware of the distinctions in deciding to include several more specific elements in Pillar 2. Pillar 1 has always represented the minimum regulatory requirement. Pillar 2 is deliberately expressed differently. For example, Pillar 2 is not described as, and is not intended to lead to, specific additional formal across-the-board requirements. Pillar 2 does not require such an approach. Nor does Pillar 2 require an explicit automatic add-on for each element mentioned in the Accord. On the other hand, Pillar 2 explicitly recognises that banks face risks not included under Pillar 1 and that many banks choose to operate at capital levels well above those implied by Pillar 1 minimums. Pillar 2 thus expresses the Committee's expectation that internationally active banks should operate above the Pillar 1 minimum. This principle is very important to the overall Capital Accord, and Pillar 2 provides considerable flexibility as to how that is achieved.

Pillar 2 explicitly recognises that national jurisdictions may have different approaches to meet the principles set out in CP3. In some cases, for example, under the existing situation certain countries do use more formalised approaches or requirements to deal with some of the issues covered by Pillar 2. The Committee expects that this will continue and explicitly recognises that it is always open to a country to impose formal requirements that are higher than the Basel minimum. What matters in meeting Pillar 2 is that information on these different approaches is shared among supervisors in order to promote consistency in application of the Accord, which is the mandate of the AIG. In fact, in this respect, the introduction of Pillar 2 has set in motion a process that will result in a better understanding of those differences. It will also promote greater exchange of information and cooperation among supervisors and more convergence of supervisory practices. But the Committee does not expect there to be perfect uniformity of approaches or results across national jurisdictions.

The Committee also notes that the need for reasonable flexibility in dealing with certain risks was precisely the reason they were included in Pillar 2 and not in Pillar 1. Thus, the Committee does not believe that reintegrating these into other parts of the framework, as some respondents suggest, would be wise at this stage.

On the particular issue of cross-border implementation of Pillar 2, the Committee's high-level principles for the cross-border implementation of the New Accord, published in August 2003, will apply. In general, the implementation of the New Accord is not a reason to change the legal responsibilities of national supervisors for the regulation of their domestic institutions or the arrangements for consolidated supervision already put in place by the Basel Committee. Nevertheless, the cross-border responsibilities for Pillar 2 assessment are a clear example of an area that should be worked out on a bilateral, collaborative basis between home and host supervisors, as the principles indicate.

Finally, there is a range of practical issues regarding how Pillar 2 will operate. The AIG has devoted considerable focus to these issues, and this will continue, particularly as approaches in national implementation become more clearly defined. The Committee will continue to conduct regular reviews of similarities and differences in approaches to identify particular issues that may need to be addressed, and it will welcome further dialogue on these matters with the industry, fellow supervisors and other interested parties.