A new Capital Adequacy Framework, supplementary documents

A new Capital Adequacy Framework, supplementary documents

Press release |

18 January 2000

The Basel Committee on Banking Supervision today issued two papers that add further detail to its proposed amendments to the Capital Accord. The first (A New Capital Adequacy Framework: Pillar Three, Market Discipline) is a consultative paper proposing guidelines for the disclosures banks should make in order to advance the role of market discipline in promoting bank capital adequacy. The second paper (Range of Practice in Banks' Internal Rating Systems) assesses the current state of practice in banks' internal rating systems and processes.

The first paper is designed to support and strengthen the proposals for market discipline in the consultative paper issued by the Basel Committee in June 1999. Its framework is based on three essential pillars: minimum capital requirements, supervisory review and market discipline. With respect to the so-called third pillar, the Committee firmly believes that supervisors have a strong interest in facilitating transparency as a lever to strengthen the safety and soundness of the banking system.

Mr William J McDonough, Chairman of the Basel Committee and President and Chief Executive Officer of the Federal Reserve Bank of New York, stated, "This paper is a component of the Basel Committee's ongoing effort to promote increased transparency and effective market discipline worldwide. It is a key part of the Committee's attempt to enhance capital disclosures and seeks to elaborate on the disclosures which advance the role of market discipline in promoting bank capital adequacy. The responses to this consultative paper will provide a key input to the Committee's work towards a new capital adequacy framework".

In the second paper, Mr McDonough noted, "The Committee is seeking to develop an alternative approach for the establishment of minimum capital requirements, based on the banks' internal credit ratings, and subject to specific standards, while also reviewing the existing standardised capital requirements for credit risk. The findings in this report will clearly guide the Committee's thinking on its further work regarding how such an internal ratings-based approach (the "IRB approach") to capital requirements might be structured. The findings will also provide input to the Committee as it works to develop the sound practice standards and guidelines banks will be expected to follow in order to qualify for this approach".

These are the last two capital-related papers to be issued by the Basel Committee before the comment period for the capital package closes on 31 March 2000.

Market Discipline

In introducing the proposals for promoting market discipline included in today's paper, Mr Jan Brockmeijer, member of the Basel Committee and Chairman of the Committee's Transparency Group, explained, "The recommendations in this paper fall into three areas: structure of capital, risk exposures and capital adequacy. The Basel Committee is firmly committed to improving public disclosure and market discipline, and seeks the industry's input on how to best achieve this objective."

The three areas of proposed disclosure are:

structure of capital: the Committee believes that public disclosure about the nature, components and features of capital provides market participants with important information about a bank's ability to absorb financial losses. The report further notes that innovative, complex, and hybrid capital instruments must be adequately disclosed since the characteristics of such instruments may have a significant impact on the market's assessment of the strength and integrity of a bank's capital;
risk exposures: the report recommends that, for each category of risk, an institution should reveal sufficient qualitative (e.g. management strategies) and quantitative (e.g. stress testing) information to permit a fair assessment of the nature and magnitude of its risk exposures. Comparative information of previous years' data should also be provided to give a perspective on trends in these underlying exposures;
capital adequacy: to help market participants assess its capital adequacy, a bank should - at least annually - disclose its risk-based capital ratio (calculated in accordance with the methodology prescribed in the Basel Capital Accord as implemented by its home country supervisor), along with any other relevant information.

The Basel Committee recognises that the recommendations contained in this paper may need to be expanded on as the new framework evolves in light of the comments being received on the June 1999 consultative paper.

Range of Practice in Banks' Internal Rating Systems

In spring 1999, the Committee's Models Task Force received a mandate from the Committee to embark on a study of banks' internal rating systems and processes, and to evaluate the options for relating internal ratings to a regulatory scheme. Ms Danièle Nouy, Chairwoman of the Models Task Force, stated, "The Committee is working towards this objective, consistent with the objectives set forward in the June 1999 consultative paper, by developing an evolutionary structure that moves rapidly toward basing credit risk capital requirements on a bank's internal ratings, to the extent that current bank and supervisory practice will allow". In the report, the Committee expands on the possible architecture of this evolutionary approach. Ms Nouy noted that this approach further allows for greater risk sensitivity - both across banks and over time - through a series of incremental improvements, to be developed as a reflection of enhancements in banks' risk management practices.

This report presents the preliminary findings of the Models Task Force's recent efforts in developing this approach - including an assessment of the current state of practice in rating systems and processes, and the range of practices across institutions. The findings are based on a survey of around 30 institutions across the G10, identified by respective national supervisors as having well-developed internal rating systems, a series of in-depth presentations from banks and other industry practitioners, and continuing work by individual Models Task Force members.

"Our analysis thus far highlights both the similarities and differences in the structure, methodology and application of internal rating systems at banking institutions," said Mr Pierre-Yves Thoraval, Bank Supervision Director at the French Commission Bancaire, and Chairman of the Working Group responsible for this report. "In particular, while it appears that there is presently no single standard for the design and operation of an internal rating system, a small number of alternative approaches emerged from our analysis." These approaches raise a number of key issues, including:

banks appear to consider similar types of risk factors when assigning a rating. However, the relative importance of these factors, and the mix between quantitative and qualitative considerations, differ between the banks surveyed, and in some cases between different borrower types within the same bank;
although banks in general take the same set of issues into account in assigning internal ratings, they utilise different approaches in doing so. These can be viewed as points on a continuum with, at one extreme, systems focused on the judgement of expert personnel, and at the other, those based solely on statistical models. These broadly different approaches to assigning ratings will probably require different approaches to supervisory review and validation;
the vast majority of banks surveyed assign these ratings based on an assessment of the borrower. Approximately half of the banks also consider the degree of risk contributed by the specific characteristics of the transaction in the rating process;
the information gleaned from ratings is utilised (or expected to be utilised) in broadly similar processes at the banks surveyed, including management reporting, pricing and limit setting;
the data sources and techniques for quantifying loss characteristics per grade (e.g. the probability that a borrower in a given grade will default on its obligations, the economic loss likely to be experienced should such a default occur - i.e. the loss-given-default - and associated parameters such as the likely level of exposure to that borrower at the time of such default) differ between banks. In particular, the survey indicates that banks in general appear to have greater difficulty in attributing loss-given-default estimates to their exposures than in assessing the probability of default of the counterparty;
data providers and banks utilise differing definitions of "default" and "loss" in assigning ratings and quantifying loss characteristics. These differences represent a source of inconsistency and/or measurement error that will need to be considered explicitly in an IRB framework; and
data availability also remains a challenge to banks' efforts to quantify risk. The survey does suggest, however, that some banks are making progress in collecting and analysing internal data for certain market segments covering the past few years. The Committee urges banks to continue in these efforts.

The Committee seeks the industry's comments on (a) whether the range of practice identified in the report is truly representative of behaviour, across both banks and countries, (b) the extent to which the range of practice identified represents "best" or "sound" practice, (c) whether important elements of a bank's rating process have been omitted or are given insufficient attention, and (d) whether the Models Task Force's preliminary conclusions in respect of some of the elements - for example, the data constraints encountered by many banks in quantifying loss-given-default - are fair and reasonable.

"The Committee is working hard to develop an IRB approach which is risk-sensitive, and which will provide incentives for banks to further improve credit risk measurement and management practices," added Mr McDonough. "Furthermore, the Committee will pay close attention to ensuring that the structure and requirements of the IRB approach do not impinge upon banks' own well-established lending and credit risk management practices."

Comments on both of the reports should be sent to the Basel Committee Secretariat, Bank for International Settlements, CH-4002 Basel, Switzerland, or by e-mail, to bcbs.capital@bis.org by 31 March 2000. Comments may also be sent to national supervisory authorities.

Notes to editors

The Basel Committee on Banking Supervision

The Basel Committee on Banking Supervision is a Committee of banking supervisory authorities established by the central bank Governors of the Group of Ten countries in 1975. It consists of senior representatives of bank supervisory authorities and central banks of Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States. Its current chairman is William J McDonough, President and Chief Executive Officer of the Federal Reserve Bank of New York. The Committee usually meets at the Bank for International Settlements (BIS) in Basel, where its permanent Secretariat is located.

The Transparency Group

The Basel Committee's Transparency Group has the lead responsibility in the Committee's consideration of public disclosure and regulatory reporting issues. It is currently chaired by Mr Jan Brockmeijer, Deputy Director at the Netherlands Bank and a member of the Basel Committee, although the paper was partly developed when Ms Susan Krause, formerly Senior Deputy Comptroller for International Affairs at the US Office of the Comptroller of the Currency, held the chair. At present, the Transparency Group has 22 members, representing all member countries and most member institutions of the Basel Committee. The Transparency Group has produced several papers recommending improved disclosure in recent years.

The Models Task Force

The Models Task Force, chaired by Ms Danièle Nouy, was set up by the Basel Committee in 1994. The Task Force consists of supervisory experts from member institutions of the Basel Committee.

Coverage of the New Framework

The 1988 Accord was designed for internationally active banks in the G10 countries. The Accord has been widely adopted and applied throughout the world, not only to internationally active banks but also, in many countries, to domestic banks. While the focus of the new Accord will again be on internationally active banks, the guiding principles, as embodied in the three pillars, are generally suitable for any bank in any jurisdiction. Full account must be taken of individual circumstances; for example, some non-G10 countries show greater volatility at the macroeconomic level. Moreover, supervisors will need to consider carefully whether the essential preconditions laid down in the Accord are met - for example, whether there are sound accounting principles and practices - and to take appropriate action where needed. Circumstances of individual banks (such as scale, diversification, risk management systems and riskiness) and of supervisors (including resources available for review), are all relevant to how and when individual countries can apply the Accord.

What is the basis of the information in the Range of Practice Report?

Since receiving its mandate, the Basel Committee's Models Task Force has been actively engaged in gathering information about banks' internal rating systems, and assessing both the "best practice" and overall sound practice in this area. As part of its information gathering, in spring 1999 the Models Task Force undertook a survey of around 30 institutions across the G10, identified by respective national supervisors as having well-developed internal rating systems. The findings of this survey were supplemented by a series of in-depth presentations from banks and other industry practitioners in September and October of last year, and continuing work by individual Models Task Force members.

The banks covered in the analysis tended to be large, diversified international banks; however, a small number of more specialised institutions was also included. This sample was selected with a view to uncovering the range of potential policy issues and considerations in constructing an IRB approach, such as the range of structures of rating systems, the various extents to which they have developed, the use to which the rating information is put, the type of portfolio rated, and the degree of reliance on expert judgement versus statistical models in assigning ratings. To a considerable extent, these decisions were guided by bank-specific rather than country-specific considerations.

What is the possible architecture of an IRB approach?

It is well beyond the purpose of this report to provide details of how such a framework would operate, and indeed proposals for addressing such details are still under development by the Models Task Force and the Committee. Nonetheless, to provide a proper context for the information contained in this report, it is useful to reduce the IRB approach to its basic elements. Based on its current analysis of bank practice, the Committee envisages that the foundation of this architecture would include the following elements:

a bank's assessment of the risk of default in a borrower, as embodied in its internal rating and the measurable risk characteristics associated with these ratings;
a system for slotting those exposures within a given bank grade into a regulatory capital bucket based - for most portfolios - on the bank's quantifiable concept of borrower default, as well as loss-given-default and potentially other asset characteristics (which may be estimated by banks or parameterised by supervisors);
development of a capital charge associated with each regulatory capital bucket based on estimates of its relative riskiness;
minimum standards and sound practice guidelines for key elements of the rating process, including key characteristics of the rating system and process; and
a supervisory process for validating this approach, including ways of ensuring that a rating reflects all relevant information on the underlying risk of an exposure, that the process by which it is assigned ensures its integrity, and that the underlying measures of loss are consistent and comparable across banking institutions and countries and over time.

The Committee intends to build on this foundation to introduce additional features and refinements. Although it may not be possible to introduce all these refinements within the Committee's time frame for an initial IRB proposal, they could be incorporated over time as bank and supervisory practices allow. Furthermore, some of these elements could be built into the initial structure and process so that, as a bank improved its practices, it would become eligible for greater supervisory recognition of these practices. These elements could include:

increasing the number of dimensions in the architecture to incorporate other asset characteristics
breaking the units of measurement in each dimension into finer gradations;
extending the degree of bank discretion in estimating key inputs as banks demonstrate the adequacy in their data collection and quality; and
introducing additional refinements for the treatment of complex instruments.

Where can I obtain the full reports?

The text of the report on market discipline, A New Capital Adequacy Framework: Pillar Three - Market Discipline and Range of Practice in Banks' Internal Rating Systems can be obtained from the BIS website (www.bis.org under "publications") as of 12.30 (CET) on 18 January 2000. The reports are also available from the Basel Committee's Secretariat at the Bank for International Settlements and from member bank supervisory authorities and central banks.