The Basel Accord free essay sample

This paper throws light on this and a number of related issues due to a combination of the novelty of the survey data from risk managers coupled with a rigorous statistical analysis. Results reflect that the Basel Accord is generally well regarded due to its underlying aims of improved capital standards and a scientific treatment of risk. However, operational risk emerges as a key barrier to implementation in Bangladesh. A number of further obstacles are highlighted, which, do seem to have been addressed although only with a partial degree of success. Privately owned banks appear to be more technically competent and more favorably disposed towards implementation than publicly owned banks. ACKNOWLEDGEMENT First of all I would like to my cordial thanks for almighty Allah whose uniqueness, oneness, and wholeness are unchallengeable guided us in difficult circumstances. All respects are for his holy prophet Hazrat Muhammad (SM) Peace be upon him, who enable us to recognize the oneness my creator. We will write a custom essay sample on The Basel Accord or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page I would like to thank Mr. Ziaul Hoque Zia, my university supervisor for guiding me in planning and composing the assignment. He was always available to provide me with his supervision and guidance during the entire course. Therefore, I express colossal appreciation for his aid. From the early hours of the morning to the sunset of the evening they have guided me through various operations of the study and provided me with essential support for my assignment. I pray to Allah that He be merciful to all of these people. Last but not the least thanks goes to my parents for bearing the tension, frustration and all the hard work along with me through the entire MBA program. EXECUTIVE SUMMARY In its depth and scope, Basel is unlike anything the banking business has seen. A combination of micro- and macro-prudential norms, the global regulatory mandate (which rolls out this year through 2018)1 requires banks to increase their quality of capital by focusing on liquidity and common equity; improve supervision of firm-wide risk management; and provide detailed reporting on regulatory capital and the calculation of capital ratios. It mandates adherence to ratios such as liquidity coverage and net stable funding, which are aimed at strengthening banks’ short and long-term liquidity. Most prominently, Basel is transforming risk management into a function that fortifies banks’ sound functioning. These changes will necessitate a fundamental review of each bank’s operating model. Many banks will need to decide which businesses and geographies to focus on and which to exit. Almost all banks will need to invest in technology capabilities to meet Basel III’s stringent data reporting and risk management requirements. While these investments will strain bank balance sheets, they will also create opportunities to extract additional efficiencies from day-to-day operations. Given the pressure on margins, we believe that banks need to go beyond the standard applications of the new technologies. By building strong capabilities in the areas that are the focus of these regulations, banks can differentiate themselves from their competitors. Key imperatives for banks as they prepare for Basel include: †¢ Undertake a fundamental analysis of individual businesses to identify growth drivers. Banks in most G-10 countries have implemented it since the early 1990s. It is now considered largely outdated and is in the process of being replaced by  BASEL II. It is also called Basel I. A set of agreements set by the Basel Committee on Bank Supervision (BCBS), which provides recommendations on banking regulations in regards to capital risk, market risk and operational risk. The purpose of the accords is to ensure that financial institutions have enough capital on account to meet obligations and absorb unexpected losses. Objective of study The primary objectives of the report are to fulfill the academic requirement of a assignment during my study which is required for the completion of MBA degree under BGC Trust University Bangladesh, and to enhance my knowledge base by probing into the details of Basel accord and how risk management sails through the required criteria’s, and how the regulates the industry through Basel. The report goes into explaining the ways of bank allocates its risk management, disclosure of market information and the coordination of Risk Rationality of study The banking industry is the backbone any country. It helps to improve the economic development of the country by advancing the needy and also helps for capital formation, resulting into increasing the employment opportunities. The authors intend to study the various risks faced by the banking industry especially after impact of subprime crisis in 2008over the world economy and its repercussions in the Indian economy. It has been therefore decided to have an in depth knowledge taken by the developed countries after 1988 in the form Basel accord. Methodology of Study For my internship report I have collected data from both the Primary sources and the secondary sources. Primary data: I got the data or information through the following ways- * Directly from the internet and books. * By observing the environmental behavior, facts, record and present condition of the BASEL. * By working in Customer Service and communicating with the clients of the bank from various industries. Secondary data: I have collected the secondary data through annual reports of Bangladesh Bank, market disclosure reports of Bangladesh bank, online newspaper articles from The Daily Star and The Financial Express, various informative websites etc. Statistical methods: Descriptive and graphical methods of calculations have been made for the mathematical representations to prepare this report. Limitation of study I have dedicated my entire efforts to enrich and complete this report although there are some limitations which are as follows: * Basel II is a comparatively newer regulation posed on banks compared to the others regulations from Bangladesh Bank; therefore few employees have sufficient information about it. Basel III has not been yet proposed for implementation by Bangladesh Bank. Bank employees are extremely busy with transactions and other purposed therefore the time that could be managed from was not enough. * Unfortunately due to the Banks limitations (business secrecy and confidentiality), I was unable to acquire sufficient information. * Personal barriers such as inability to understand some official terms, office decorum created a few problems for me. * Time was also a limitation. Gathering such an amount of information by only working for three months was an extremely difficult job. Part-2 An Overview of BASEL The first Basel Accord, known as Basel I, was issued in 1988 and focuses on the capital adequacy of financial institutions. The capital adequacy risk, (the risk that a financial institution will be hurt by an unexpected loss), categorizes the assets of financial institution into five risk categories (0%, 10%, 20%, 50%, 100%). Banks that operate internationally are required to have a risk weight of 8% or less. The second Basel Accord, known as Basel II, is to be fully implemented by 2015. It focuses on three main areas, including minimum capital requirements, supervisory review and market discipline, which are known as the three pillars. The focus of this accord is to strengthen international banking requirements as well as to supervise and enforce these requirements. Basel III is a set of standards and practices created to ensure that international banks maintain adequate capital to sustain themselves during periods of economic strain. Basel III adds further controls to those required by  Basel-II, which in turn was a refinement of Basel I. Bangladesh status Basel II would be implemented from January 2009. In this regard a quantitative impact study (QIS) to assess the preparedness for implementing Basel II as well as the bank’s view on the optional approaches for calculating Minimum Capital Requirement (MCR) as stated in Basel II was carried out in April-May 2007. Study amp; subsequent discussion with few related banks reveal that bankers should be more acquainted with the New Capital Accord (Basel-II). To address this challenge capacity building of concerned implementing amp; supervisory officials should be given first priority in the Action Plan/Roadmap. Basel II may be implemented with the ollowing specific approaches as initial steps: a) Standardized Approach for calculating Risk Weighted Amount (RWA) against Credit Risk supported by External Credit Assessment Institutions (ECAIs) b) Standardized Rule Based Approach against Market Risk and c) Basic Indicator Approach for Operational Risk. From January 1, 2010 Bangladesh Bank instructed all the scheduled banks to follow the instructions regarding Minimum Capital Requirement (MCR), adequate capital and disclosure requirement as stated in the guidelines on Risk Based Capital Adequacy (RBCA) for the purpose of statutory compliance (Rahman, 2012). According to the accord, a banks minimum capital must be TK400 crore by August 11, 2011. Of the amount, Tk 200 crore must be in paid-up capital (Rahman, 2012). On the other hand, the RBCA ratio has to be a minimum 10 percent of assets. BASEL II and BASEL III Implementation by BANK RISK MANAGEMENT following the statutory requirements of BANGLADESH BANK34 The Basel II accord has been prepared on the basis of three pillars: minimum capital requirement, supervisory review process and market discipline. And three types of risks credit risk, market risk and operational risk have to be considered under the minimum capital requirement (Rahman, 2012). Earlier in 2009, Bangladesh Bank allowed commercial banks to raise their capital even by subordinated debt (Rahman, 2012). Under the accord, risk of assets of a bank client must be rated by external credit rating agencies, otherwise provision will be higher at 125 percent instead of 50 percent which is for rated ones (Rahman, 2012). Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability (Wikipedia, 2012). Part-3 Major Findings of Analysis 1. Key risks There are many banking risks. Most common approach is to group banking risks to credit risk, liquidity risk, market risk and operational risk. Credit risk Credit risk is described as the risk to have losses because counterparty is not capable to carry out its obligations according to the terms of the agreement. Sometimes losses occur even when the counterparty does not breach the contract, but there are certain signs showing increasing probability of borrower’s insolvency (e. g. downgrade in credit ratings of the borrower). Credit risk is one of the key risks for the banks as failure to properly evaluate it may lead to insolvency and bankruptcy. Aggregated stress testing of Lithuanian banks results of the yr. 2002 showed that banks consider credit risk to be the most important risk, constituting over 62% of possible losses [6]. Basel II suggests 3 alternative approaches for credit risk management – Standard approach, Foundation Internal Ratings Based (F-IRB) approach and Advanced Internal Ratings Based (A-IRB) approach. Using standard approach, capital coverage is calculated by applying certain risk weights to certain balance sheet items. Internal ratings based approaches calculated capital coverage as function of PD (probability of default), LGD (loss given default), EAD (exposure at default) and M (maturity). The difference between F-IRB and AIRB is that under F-IRB approach banks rely on more supervisory estimates than under A-IRB approach [3]. Besides alternative approaches for capital coverage calculation, classic credit risk management tools such as limit systems, credit scoring procedures, loan assessment procedures, risk diversification rules, etc. are necessary to use to keep credit risk as low as possible. Liquidity risk Liquidity risk is also risk of key importance to commercial banks as failure to properly manage this risk may result in insolvency of the bank. Liquidity risk involves the possibility that earnings or capital will be negatively affected by an institution’s inability to meet its obligations when they come due. Liquidity risk is the risk that the financial institution cannot settle an obligation for full value when it is due (even if it may be able to settle at some unspecified time in the future). Liquidity problems can result in opportunity costs, defaults in other obligations, or costs associated with obtaining the funds from some other source for some period of time [7]. In most cases, liquidity risk is the outcome of other risks such as credit, strategic, reputation, interest rate and counterparty risk. For instance, when important large customer becomes default, bank may have difficulties in meeting its obligations. Additionally, liquidity risk comes in the normal course of business, usually as long-term assets are financed by short-term obligations. Liquidity risk is managed by analysing liquidity gaps (simple and marginal), using cash matching approach by setting limits for absolute or relative liquidity gaps, making projections of future cash flows, scenario testing. Value-at-risk (VaR) techniques using statistical data may be used for these purposes. Market risk Market risk is the risk of adverse deviations in price of financial items (equities, bonds, FX deals, derivatives, etc. Market risk includes currency risk, interest rate risk, equity or debt security price risk etc. market risk may result both in positive and negative effects. In capital charge calculation, only the negative effects are taken into account. Main goal in market risk management is to reliably estimate likely price fluctuations and to take decision whether to take the risk or to reduce it. Limit systems, gap analysis, correlation analysis, instrument sensitivity analysis, market volatility analysis can be used for market risk management. The risk can be reduces by portfolio diversification or hedging using derivative financial instruments (swaps, forwards, options, etc. ). Market risk can be measured by using risk weights or by using value-at-risk approaches. It’s important to note that in order to reach best risk management results, VaR-based approaches should be used in combination with other risk management methods as VaR models rely on certain assumptions, not every time equilibrium between the accuracy and operativity is reached, output on the same data using different VaR models may vary substantially. Operational risk The definition of operational risk varies considerably since the list of factors causing operational risk is incomplete and constantly growing due to increasing complexity of business. Basel Committee on Banking Supervision defines operational risk as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and systems, or from external events [1]. Risk may actualise in technical level (IT system or risk measurement system inefficiency) or in organizational level (lack of procedures, non-adequate organization of risk monitoring and reporting) [4]. Basel Committee on Banking Supervision considers operational risk to be of high importance, that’s why Basel II demands capital charge calculation for operational risk. Stress testing of Lithuanian banks in 2002 showed that Lithuanian banks consider that losses from operational risk would make 5% of all the losses [6]. Quantitative Impact Study 3 (QIS 3) calculation shows that operational risk capital charges increase regulatory capital by 5-15% [2]. As it is impossible to name all the risks, it is suggested to determine factors causing operational risk. After that the following algorithm can be used in determining whether to ignore the risk factor, or to take action. After meticulously probing through the Annual the Bangladesh Banks â€Å"Guidelines on Risk based Capital Adequacy (Revised regulatory capital Framework for banks)†, I found that it is a very complex set of instructions and mathematical terms which demands a separate department in the bank for its integration purpose. And the instructions are very hard to understand about the global standard regulatory policy or the whole banking industry. Basel II has been made mandatory for all the scheduled banks in Bangladesh since January 2010. Bank Asia Ltd has been maintaining a healthy CAR ratio all throughout the 2011 fiscal year. The problems in the implementation of the requirements have to be mitigated as soon as possible. The data collected from all the branches and the corporate office should be centralized for further accurate results. One of the most frequent reports related to Basel II is Stress Test. A report of such importance loses value when it is submitted so soon after the previous one because three month’s time is a small window to see material change in the variables. Even the variables are tested with unrealistic shocks keeping other variables constant. There are three types of shocks- minor, moderate and major. A combined shock should be applied to see realistic result of the bank’s sustainability rather than applying an extreme shock with keeping all other things constant. So stress test should be a â€Å"scenario analysis† rather than a â€Å"what if Analysis†. It will become very complex but very realistic than current stress test measure. the Capital Adequacy Ratio (CAR) of Bank Asia reached- 14. 2% on actual capital which is greater than the ratio of 8. 11% of the year ended 2010. The second Basel Accord, Basel II, supplemented the original agreement by setting new minimal capital requirements, again based on risk profiling, but also introducing two new pillars: supervisory review and market discipline. Basel II was very short-lived in relation to its predecessor as it was promulgated during the onset of the global financial crisis. In response to a number of failings in Basel II, which came to light during the crisis, a further modification, Basel III, was initiated in 2010. Conservative Risk Management is the hallmark of the Basel II framework for mobilizing financial stability across banking sectors worldwide (BCBS, 2006). This framework built on the basic premise of capital management as suggested by Basel I in 1988, but provided improved parameters, reflecting a clearer formulation of risks facing the banking sector and a mechanism for protecting banks against risk in a more methodical and scientific manner. The Basel Accord re-engineered the organizational structures and processes of the supervisors and the banking sectors all around the world. The key to the effective and improved risk management under the Accord is its proper implementation (AIF: Disclosure Subcommittee,2004). Accordingly, in order to have effective implementation around the world, co-operation between global supervisors and the respective institutions plays a pivotal role (Global Risk Regulator, 2005). The primary purpose of the Basel Accord is therefore to promulgate the three pillars of Basel II by rationalizing banks’ risk appetite according to their residual resources, thus forming the basis of a sound banking structure. In Bangladesh banks are regulated by the Banking Supervision Department of the State Bank of Bangladesh. It has set-up a road map for the implementation of Basel Accord which attempts to comply with Basel Accord Implementation guidelines issued by the BCBS. With the growth of international banking and the entrance of multinational banks into Bangladesh’s Banking Sector the diversity of the domestic Banking Sector has increased. This has also increased the public availability of banking services matching international standards. These developments have changed the nature of the risks facing the Bangladeshi banking system – risks that the very promulgation of the Basel Accord was intended to address. The multi-layered structure of the Basel Accord and different levels of adoption around the world – creates further confusion. In Pakistan, it was originally intended that the Basel Accord would be implemented in full before December 31st 2009. However, the State Bank of Bangladesh extended the dates for implementation for various special circumstances that the Bangladeshi Banking Sector faces. The fact that Bangladesh’s implementation of the Basel Accord lags behind that of other countries is also significant (see Section 3). There is thus a need to investigate the reasons behind this from a local perspective, over and above the international reasons stemming from the international banking crisis. In this regard research needs to be undertaken focusing upon the following issues: ? Compliance to the timetable introduced by the Supervisory Authorities; ? Problems faced by both the State Bank of Pakistan and individual banks; ? The present and proposed infrastructure available with the Basel Accord for smooth and successful implementation; ? HR capabilities; ? The impact the Basel Accord has upon bank exposures to credit, market and operational risks. 4 This paper will explore various aspects of Basel Accord Implementation in Pakistan, thus clarifying the inability of Pakistani Banks to adopt the advanced techniques in the Accord. Previous studies have looked at the impact of implementation of the Basel Accord in a number of different countries including the United States, Brazil, Switzerland, India, Lebanon and South Africa (Jacobsohn, 2004;Cumming and Nel, 2005). However, no such study has yet been conducted in Pakistan. Further, most of these studies were conducted prior to the introduction of the Second Accord. It is therefore of interest to undertake a fresh study into the implementation of the Basel II Accord in Pakistan, both due to the timing (after Basel II and following the recent financial crisis and the subsequent commencement of Basel III) and due to the unique set of circumstances facing the Pakistan banking sector following its recent expansion. The layout of this paper is as follows. Given the potential impacts on corporate governance, financial analytics, business processes and data management, the implementation of Basel III may well represent the most significant series of steps and challenges in these endeavors. The success of risk management organizations in meeting these challenges will be evidenced by the creation of data-rich environments able to support financial modeling, stress-testing, analytics, and reporting, which in turn will lead to a level of transparency that enables markets to assess risk management profiles and capabilities and, ultimately, capital adequacy. The implementation of both Basel II and Basel III requirements should not be seen only as a regulatory milestone to be addressed on a stand-alone basis within the organization. The key benefits for the overall banking system as well as for each individual bank come from integrating risk management practices with an organization’s day-to-day business and strategy, resulting in better financial health for all. Companies that have most successfully managed their businesses have given the risk function a more central role in the organization. However, this centralized view of risk should not imply that risk management will have a limiting effect on business development; rather, it implies that every decision must take into consideration the risk perspective and integrate it with a new, global performance management view to optimize business opportunities that carry an inherent risk. The road to achieve a more mature risk-management model is a long one. However, our experience shows that successfully implementing a well-defined risk management strategy will increase the likelihood of a well-structured implementation of a Basel Program.