ProdukHukum BankIndonesia
BASEL I I AT GLAN CE
I m ple m e n t a t ion of Ba se l I I in I n don e sia
Ba n k I n don e sia
D ir e ct or a t e of Ba n k in g Re se a r ch a n d Re gu la t ion
1
Ta ble of Con t e n t s
Fo r ew o r d
Bas el I I at a Gl an ce
Ban k Cap i t al
Th e Cap i t al A d eq u acy Rat i o ( CA R)
D ef i n i t i on o f Reg u l at o r y Cap i t al
Mi n i m u m Cap i t al Rat i o
Ri sk W ei g h t i n g s
S
Et ruct ure of Basel I I
Bas el Cap i t al A cco r d
Pi l l ar 1 —D ef i n i t i o n o f Capi t al , Mi t i g at i o n o f Cr ed i t Ri sk
Mar k e t Ri sk , Op er at i o n al Ri sk
Pi l l ar 2 —S u p er v i so r y Rev i ew Pr o ces s
Pi l l ar 3 —Mar k e t D i scl o su r e
Fr eq u en t l y An sw er ed Qu est i o n s
Gl o ssar y
2
Forew ord
The purpose of t his book is t o help readers underst and t he im port ance of capit al, not
only for individual banks, but also in safeguarding financial syst em st abilit y. Because of
t his vit al role, t he regulation of bank capit al is guided by int ernat ional st andards issued
by t he Basel Com m it t ee on Banking Supervision. The Basel I st andard, init ially adopt ed
in 1988, has undergone num erous changes over t im e in response t o t he rapid
developm ent of financial m arket inst rum ent s. Ult im at ely, agreem ent was reached on a
m ore risk sensit ive st andard for calculat ion of bank capit al known as Basel I I .
This sim ply- worded book is designed t o inform readers of t he process of change in
capit al st andards and t he background t o t he issuance of Basel I I , in which bank capit al
adequacy is linked t o t he risk profile of t he individual bank.
This book does not delve int o t he in dept h t echnical det ail on each aspect of Basel I I , but
rat her is aim ed m ore at present ing a com m on line of t hought for Basel I I , t hat of
im proving bank risk m anagem ent in order t o provide bet t er assurance of financial
syst em st abilit y, which will ult im at ely support econom ic growt h.
Jakart a, Sept em ber 2006
3
Basel I I at a Gla nce
I m pr ove d St a n da r d for Ca pit a l Ade qu acy
A bank provides an int erm ediat ion funct ion for funds received from cust om ers. Failure of
a bank will result in widespread im pact affect ing ret ail and inst it ut ional cust om ers who
hold funds at t he bank. This could t rigger m ult iplier im pact s on
t
he dom est ic and
int ernat ional m arket . The im port ance of t he banking role dem ands proper regulat ion, in
which t he prim ary obj ect ive is t o m aint ain cust om er confidence in t he banking syst em .
An essent ial part of t he regulat ory fram ework for t he banking syst em involves t he
regulat ions governing bank capit al, which funct ions as a buffer against losses.
I n view of t he im port ance of capit al t o banks, BI S issued a capit al fram ework concept
m ore com m only known as t he 1988 accord ( Basel I ) . This syst em was designed as a
fram ework for m easurem ent of credit risk and est ablished a m inim um capit al st andard at
8% . The Basel Com m it t ee designed Basel I as a sim ple st andard requiring banks t o
disaggregat e t heir exposures int o broader cat egories reflect ing debt or sim ilarit ies.
Exposures t o cust om ers of t he sam e t ype ( such as exposures t o all corporat e cust om ers)
are subj ect t o t he sam e capit al requirem ent s wit hout t aking account of differences in
loan repaym ent capacity and specific risks associat ed wit h t he individual cust omer.
More t han a decade lat er, prom pt ed by t he evolut ion of banking worldwide and t he
reality t hat t he best m et hod for calculat ing, m anaging and m it igat ing risks would be
different from bank t o bank, t he Basel Com m it t ee em barked on t he init iat ive for revision
of Accord 1988. The growing diversit y and sophist icat ion of product s in t he banking
syst em led BI S t o int roduce im provem ent s t o t he capit al fram ework in t he 1988 accord
wit h t he launching of a new capit al concept known as Basel I I . The first proposal w as
released in 1999 and was slat ed for im plem ent at ion at end- 2006. The revised capit al
accord—Basel I I —is a com prehensive agreem ent t hat est ablishes a spect rum of m ore
risk - sensit ive capit al allocat ion and incent ive for im provem ent s in t he quality of risk
m anagem ent at banks. This was achieved by adj ust ing capit al requirem ent s t o credit risk
and operat ional risk, and int roducing changes in calculat ion of capit al t o cover exposures
t o risks of losses caused by operat ional failures. I n addit ion t o t he calculat ion of
m inim um bank capit al, Basel I I also provides for a supervisory review process t o ensure
t hat banks m aint ain a level of capit al com m ensurat e t o t heir risk profile and prom ot es
m arket discipline t hrough disclosure requirem ent s.
BASEL II
MARKET
DISCIPLINE
SUPERVISORY
REVIEW
PROCESS
MINIMUM
CAPITAL
REQUIREMEN
3 PI LL ARS
Providing a flexible, risk-sensitive capital
mana gement f ramework
The obj ect ive of Basel I I is t o st rengt hen t he securit y and soundness of t he financial
syst em by reinforcing t he em phasis on risk- based calculat ion of capit al, t he supervisory
review process and m arket discipline. The Basel I I Fram ework is based on a forward-
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looking approach t hat enables im provem ent s and changes t o be m ade over t im e. I n t his
way, t he Basel I I fram ework is able t o keep pace wit h changes in t he m arket place and
developm ent s in risk m anagem ent .
At first glance, Basel I I involves various com plexit ies and precondit ions t hat are difficult
for banks t o m eet. However, t he ext ra effort is well j ust ified in view of t he benefit s t o
banks from m ore econom ic use of capit al in covering t heir risks. Banks also benefit from
t he int ernat ional recognit ion of t he Basel I I st andards, which enables a bank int ending t o
operat e globally t o be readily accept ed on t he int ernat ional m arket , provided t hat t hese
standards are m et .
M a x im isin g t h e Be n efit s of Ba sel I I
Basel I I calculat es t he capit al requirem ent according t o t he bank risk profile and cont ains
incent ives for im provem ent in risk m anagem ent wit hin t he banking syst em . By using
various approaches t o m easure credit risk, m arket risk and operat ional risk, t he result
obt ained is m ore risk- sensit ive allocat ion of bank capit al. I n Basel I I , t he calculat ion of
bank capit al is prescribed in Pillar 1 – t he Minim um Capit al Requirem ent . The alt ernat ive
approaches can essent ially be aggregat ed int o t wo m aj or groups: t he st andardised
m odels t hat apply t o all banks and t he m ore sophist icat ed int ernal m odels developed as
appropriat e t o t he nat ure of business and risk profile of t he individual bank.
A com parison bet ween t he t wo m aj or approaches reveals t hat int ernal m odels can
generally be expect ed t o generat e m ore precise capit al adequacy calculat ions
appropriat e t o t he risks faced by t he bank. This will offer banks an incent ive t hat is
expect ed t o prom ot e sust ained effort s t o build t he qualit y of risk m anagem ent . I n t his
way, over t im e, banks will m axim ise t he benefit of t he m ore sophist icat ed approaches in
calculat ing t heir capit al requirem ent .
Minimum Capital Ratio = 8% =
Capital (Tier 1 + Tier 2 + Tier 3)
Risk-Weighted Assets
Market Risk
Credit Risk
Operational
Risk
Risk of loss from
on and off balance
sheet positions
from changes in
market factors
(interest rates and
exchange rates)
Risk of loss from
default by
debtors/
counterparties
Risk of loss directly
or indirectly caused
by weaknesses or
failures in internal
processes, human
resources and
systems and by
external events
Significant
Changes
Additional
Risk
No Significant
Changes
5
I n assessing bank capit al adequacy, it is not only necessary t o allocat e capit al on t he
basis of Pillar 1, but also capit al t o ant icipat e losses from ot her risks, such as liquidity
risk, st rat egic risk, int erest rat e risk in t he banking book and ot her risks. This approach
is capt ured in Pillar 2, t he Supervisory Review Process, and is referred t o as t he
I ndividual Capit al Adequacy Assessm ent Process ( I CAAP) . I t will pose an im port ant
challenge for banks and supervisors. Building of supervisor com pet ence and capacit y will
be essent ial, as also t he support of t he regulat ory fram ework for bank supervision. Wit h
t im e, supervisors will becom e effect ive in t he assessm ent of risks ot her t han t hose
covered in Pillar 1 and m ay even order banks t o add t o t heir capit al if bank capit al is
deem ed inadequat e.
Furt herm ore, t he act ive public role in scrut iny of banks is seen as crucial. From t he
beginning, t he public will also be expect ed t o assess bank risks and ascert ain t he level of
capit al adequacy as envisaged in Pillar 3 – Market Discipline. The synergy of t he t hree
Pillars in Basel I I is int egral t o building a sound and st able banking indust ry and financial
system .
I m pa ct of Ba sel I I on t h e Re silien ce of t h e Ba n k in g Syst e m
1 . W ill Base l I I ca u se ban k CAR t o drop be low t he 8 % m inim um ?
Bank I ndonesia is now working t oget her wit h a num ber of banks on a periodical
st udy of quant it at ive im pact t o assess t hec onsequences of Basel I I on bank capit al.
For t his reason, the im pact of Basel I I should be exam ined on an individual basis. I t
is necessary t o perform assessm ent s and im prove t he effect iveness of risk
m anagem ent from an early st age in order t o gain m axim um advant age from t he
available incent ives. A drop in t he CAR could well occur for banks wit h a higher risk
profile. However, banks whose credit port folios are dom inat ed by ret ail loans and
hom e m ort gages will see a reduct ion in t heir capit al requirem ent because of t he
lower risk weight ings t hat will apply t o ret ail loans and hom e m ort gages.
2 . W ill Ba sel I I be im ple m en t ed for a ll com m e rcial ba n k s?
The focus of Basel I I in I ndonesia is developm ent and im provem ent in risk
m anagem ent wit hin t he nat ional banking syst em . This was set out in Bank I ndonesia
Regulat ion No. 5/ 8/ PBI / 2003 dat ed 19 May 2003 concerning Applicat ion of Risk
Managem ent for Com m ercial Banks. These m easures will apply t o all banks
regardless of size, given t hat t he risk m anagem ent cult ure should becom e st andard
pract ice in t he banking business. Survey shows t hat banks would prefer Basel I I t o
be im plem ent ed across t he board. The m ain reason is t o m inim ise t he negat ive
im pact on com pet it ion t hat would arise from different iat ions by ability and readiness
of banks t o im plem ent and develop risk m anagem ent and t he associat ed
infrast ruct ure. Furt herm ore, all banks in I ndonesia will be able t o apply t he st andard
approaches in Basel I I .
3 . Could Ba se l I I h a m pe r t h e in t e r m e dia t ion pr oce ss?
Basel I I is not int ended t o ham per t he int erm ediat ion process current ly in operat ion
in t he banking syst em . At t he m acro level, it also does not seek t o reduce t he
dom inant role of t he banking syst em in financing econom ic act ivit ies. The overall
t hrust of t he approaches put forward in Basel I I is int ended m ore as an effort t o
reposit ion and redefine what has been achieved by t he banking syst em , wit h focus on
im proving risk m anagem ent .
I n regard t o t he int erm ediary funct ion, Basel I I is not a m echanical capit al regi m e
wit h no room for t olerance. Room for flexibilit y is assured by a num ber of nat ional
discret ion clauses. While Basel I I is expect ed t o see reduced exposures t o cert ain
6
sect ors ( e.g. because of t he use of rat ings in lending t o corporat e ent it ies) , on t he
ot her hand it will also encourage increased exposures t o ot her sect ors, such as ret ail
lending ( e.g. sm all- scale business credit , personal loans and so on) and housing
m ort gages t hrough reduced risk weight ings. I t is underst ood t hat t his shift in
exposures will bring som e shock t o banks, debt ors and t he econom y as a whole.
Even so, t his effect is not expect ed t o last long, and will be no m ore t han a fine
t uning cust om ary t o any econom y.
4 . W h at w ill be t h e im pa ct for ba nk s cu rr e nt ly w ork ing on r a ising t h eir ca pit a l
for t h e im ple m e n t a t ion of t h e I n don esian Ba nk ing Ar ch it e ct u r e?
Raising addit ional capit al for t he purposes of t he I ndonesian Banking Archit ect ure will
not in it self provide t he m eans for a bank t o achieve full com pliance wit h Basel I I .
However, a n adequat e capit al base will enable a bank t o develop t he hum an
resources and inform at ion t echnology capabilit ies essent ial for Basel I I . I n t his way,
t he Rp 80 billion t ier 1 capit al requirem ent for com m ercial banks, t o be m et by t he
end of 2007, and t he Rp 100 billion requirem ent for t he end of 2010 will not only
expand t he econom y of scale in conduct ing operat ions, but also provide opport unit y
for t he bank t o st rengt hen it s risk m anagem ent capabilit ies for im plem ent at ion of
Basel I I .
5 . W h a t a r e t h e pr er e qu isit es for proper im plem e nt a t ion of Ba sel I I ?
Condit ions t hat m ust be sat isfied for proper im plem ent at ion of Basel I I include:
-
Applicat ion of risk m anagem ent pract ices in t he banking syst em as st ipulat ed
in Bank I ndonesia Regulat ion No. 5/ 8/ PBI / 2003 dat ed 19 May 2003
concerning Applicat ion of Risk Managem ent for Com m ercial Banks
-
Adj ust m ent s in account ing st andards in keeping wit h int ernat ional account ing
st andards ( I AS) , including but not lim it ed t o I AS 32 and I AS 39
-
Consolidat ed calculat ion of bank capit al t o cover com panies in t he sam e group
operat ing in t he financial sect or, wit h t he except ion of insurance com panies
-
Recognit ion of a rat ing agency t o enable obj ect ive rat ing of bank debt ors.
Roa dm ap for Basel I I in I n done sia: W h a t Ba n k I n don esia a n d t h e Ba nk ing
Syst e m M ust D o t o Pre pa re
Basel I I st at es t hat each supervisory aut hority m ust weigh priorit ies before adopt ing
Basel I I . I n im plem ent ing Basel I I , Bank I ndonesia is essent ially seeking t o st rengt hen
risk m anagem ent so t hat banks willb ecom e m ore resist ant t o dom est ic, regional and
int ernat ional shocks. Bank I ndonesia has developed a realist ic form at t o be followed in
t he im plem ent at ion of Basel I I t hat t akes account of t he current condit ion of t he banking
indust ry. For t his reason, t he default m ode for im plem ent at ion will be t o t ake t he
sim plest pat h, i.e. t he st andardised approach. This m eans t hat all banks will m ake
adj ust m ent s t o t heir capit al adequacy calculat ions on t he basis of t he Basel I I guidelines.
Basel I I also provides for nat ional discret ion, in which som e m at t ers are decided by t he
local supervisory aut horit y. Judgem ent s can t herefore be m ade for t he condit ion of t he
I ndonesian banking syst em and com plexit y of I ndonesia's banking product s.
As part of t he ongoing consult at ions on t he subst ance of Basel I I , including nat ional
discret ion, Bank I ndonesia has set up a working group t oget her wit h t he banking syst em
t o develop recom m endat ions on t he m ost appropriat e regulat ory fram ework. These
recom m endat ions will t hen be set out in a Consult at ive Paper ( CP) t o be dist ribut ed t o
st akeholders and especially banks in order t o invit e opinions, suggest ions and input s.
7
There have been widespread m isunderst andings am ong bankers t hat banks will be
required t o adopt m ore advanced approaches dem anding heavier invest m ent in
expensive I T and dat abases, a requirem ent t hat would obviously place banks under
financial st rain. I n principle, banks are given flexibilit y t o adopt m ore advanced
approaches, such as I RB, provided t hat t he necessary preparat ions in I T, hum an
resources and syst em s are com plet e and t he bank risk profile offers assurance t hat t he
use of a m ore advanced approach would offer benefit s for t he bank. I n t hese cases,
banks m ay apply t o Bank I ndonesia for approval. The BI supervisors will validat e t he
st at e of preparedness of t he bank before perm it t ing t he bank t o calculat e capit al
adequacy using int ernal m odels. Bank I ndonesia is now providing special t raining t o
bank supervisors who will becom e validat ors of m arket risk and validat ors of credit risk.
Use of Risk Calculation
Approach
PILLAR 1
Publish BI
Regulations
Parallel Run
(Standardised) 1) or
Validation Process
(Internal Model)
CAR
Method
Effective
Improvements
to Commercial
Bank Report
PILLAR 2
PILLAR 3
Other Risks 4)
Transparency
Online System
Issue BI
Regulations
CAR Method
Effective
Publish BI
Regulations
Q3/2007
Q1/2009
Q1/2009
Market Risk
Standardised 2)
Q3/2007
Q1/2008 – Q4/2008
Q1/2009
Q4/2008
Internal Model 3)
Q3/2007
Start Q3/2007
Q2/2008
Q2/2008
Q1/2009
Credit Risk
Standardised
IRBA 3)
Q3/2007
Q4/2009
Q1/2008 – Q1/2009
Start Q1/2010
Q1/2009
Q4/2010
Q4/2008
Q4/2010
Q1/2009
Q2/2011
Basic Indicator
Standardised 3)
Q3/2007
Q4/2009
Q1/2008 – Q1/2009
Start Q1/2010
Q1/2009
Q4/2010
Q4/2008
Q4/2010
Q1/2009
Q2/2011
AMA 3)
Q4/2009
Start Q1/2010
Q2/2011
Q4/2010
Q2/2011
Operational Risk
I m ple m e n t a t ion of Ba se l I I in Ot he r Coun t rie s
I n cont rast t o t he G- 10 count ries, non G- 10 nat ions do not com e under any deadline for
im plem ent at ion of Basel I I . This is consist ent wit h t he underlying nat ure of Basel I I ,
which does not const it ut e a legally binding docum ent im posing sanct ions on non com plying count ries. Furt herm ore, assessm ent of a count ry’s financial sect or st abilit y will
not be based on im plem ent at ion of Basel I I , but m ore on t hat count ry’s com pliance wit h
t he 25 B asel Core Principles for Effect ive Banking Supervision ( BCP) . For t his purpose,
I ndonesia has m ade st eady im provem ent s in com pliance with t he BCP in recent years.
I ndeed, t he sheer diversit y of preparat ions and policies m eans t hat each count ry will
follow a unique pat h in im plem ent ing Basel I I . The condit ion, st ruct ure and business
com plexity of t he banking syst em and quality of bank supervision are t he m ain fact ors
t hat will be t aken int o account in est ablishing t hese policies. I n t he Unit ed St at es, for
exam ple, t he advanced I RB ( A- I RB) will be adopt ed by only t he 10 leading banking
groups widely known for t heir int ernat ional operat ions. Ot her banks will apply a Basel I I
form at known as Basel 1A.
8
Ba nk Ca pit al
For banks, as for com panies in general, capi t al funct ions not only as t he m ain resource
for financing operat ions, but also provides a buffer against possible losses. Capit al also
helps t o m aint ain public confidence in t he abilit y of a bank t o operat e in t he
int erm ediat ion of cust om er funds.
The bank supervision aut horit y is responsible for ensuring a m inim um adequacy of bank
capit al by est ablishing rules concerning t his issue. Regulat ory Capit al is t he capit al
requirem ent prescribed by t he supervisory aut hority as a buffer against pot ent ial losses.
The requirem ent s applying t o Regulat ory Capit al are a key com ponent of bank
supervision and are reflect ed in t he definit ion of regulat ory capit al and t he capit al
adequacy rat io ( CAR) .
D e f i n i t i o n o f R e g u l a t o r y Ca p i t a l
A general definit ion of capit al was first int roduced in Basel I , t he first broad approach t o
capit al adequacy. This definit ion has rem ained unchanged and is ret ained in Basel I I .
The definit ion st at es t hat regulat ory capit al is divided int o t hree t iers. An it em m ay be
grouped int o one of t hese t iers, provided t hat it sat isfies cert ain crit eria. The definit ion of
regulat ory capit al set s out t he crit eria for cat egorisat ion as an elem ent of capit al, and
t hus ensures consist ency of capit al adequacy am ong different nat ions. This has
prom ot ed m ore com m on underst anding am ong banks in general and t he m ore
int ernat ionally act ive banks in part icular.
Under Basel I and Basel I I , regulat ory capit al is divided int o t hree levels or t iers of
capit al as follows:
o
Tier 1 capit al. This t ier c onsist s of inst rum ent s wit h t he great est capacit y t o absorb
losses arising at any t im e.
o
Tier 2 capit al. This t ier consist s of a broad m ix of equit y com ponent s and hybrid
capit al/ debt inst rum ent s. Tot al Tier 2 capit al is rest rict ed t o 100% of Tier 1 and is
divided int o t wo cat egories:
?
Upper Tier 2, rest rict ed t o 100% of Tier 1 capit al,
?
Lower Tier 2, rest rict ed t o 50% of Tier 1 capit al.
o
Tier 3 capit al was added in 1996 , and is used only t o m eet capit al requirem ent s for
m arket risk.
Th e Ca pit al Adequ a cy Ra t io ( CAR)
The obj ect ive of t his rat io is t o ensure t hat banks are capable of absorbing losses
incurred in t he course of t heir act ivit ies. The exist ing regulat ory rat io is t he 8%
m inim um . This links bank capit al t o t he risk weight ings of asset s held by t he bank.
Supervisor risk weight ing is t he percent age used t o convert t he nom inal value of credit
exposures t o a specific value reflect ing level of risk. The risk weight ing for each asset is
prescribed in a Bank I ndonesia regulat ion. The capit al t hat m ust be allocat ed t o cover
pot ent ial loss in relat ion t o t he exposures is obt ained by m ult iplying t he exposure value
by t he weight ing for t he asset s and t he m inim um capit al requirem ent ( i.e. 8% ) .
Som e banks have begun using capit al adequacy assessm ent approaches as a risk
m anagem ent funct ion. Banks will norm ally assess t he am ount of capit al required t o
cover loss up t o a cert ain level of probabilit y. The developm ent of t hese approaches has
9
been driven by evidence t hat capit al is a very cost ly resource for a bank. The bank m ust
t herefore have st rong incent ives t o m anage capit al as effect ively as possible. Since t he
m id-1990s, som e of t he world's largest and m ost sophist icat ed inst it ut ions have
developed various m easures of econom ic capit al and have specifically com bined t hese
wit h risk m anagem ent syst em s for m ore efficient m anagem ent of risks and capit al.
The obj ect ive of bank supervision is t o ensure t hat banks conduct t heir operat ions in line
wit h prudent , sound principles. To t his end, banks m ust m aint ain adequat e capit al and
reserves t o offset risks arising in t he course of business. The m ain principles of t he Basel
Com m it t ee on Banking Supervision ( BCBS) st at e t hat bank supervisors m ust est ablish a
safe and appropriat e level of m inim um capit al requirem ent for all banks. The ult i m at e
goal of all aut horit ies involved in bank supervision is t o prot ect t he st abilit y and
soundness of t he financial syst em . Since t he end of 1980, st andardised calculat ions of
bank capit al based on t he BCBS guidelines have com e int o widespread int ernat ional use
in support of t his goal.
Com pliance wit h t he m inim um capit al requirem ent ( or solvency rat io) is det erm ined by
t wo com ponent s as follows:
o The risk weight ings for bank asset s—i.e. all bank exposures convert ed int o asset s
wit h each exposure t hen m ultiplied by t he supervisor risk weight ing, based on level
of risk
o 2 m inim um rat ios ( or lim it s) in which regulat ory capit al is linked t o asset risk
weight ings:
Regulat ory capit al divided by risk- weight ed asset s m ust be equal t o or great er
t han 8%
Tier 1 capit al divided by risk- weighted asset s m ust equal at least 4% .
10
S T R U CT U R E O F B A S EL I I
The new capit al adequacy fram ework - Basel I I - offers great er flexibilit y by est ablishing
a num ber of risk- sensit ive approaches and incent ives for im proved risk m anagem ent .
Banks are asked t o allocat e less capit al for count erpart ies wit h higher rat ings and m ore
capit al for t hose wit h higher risk. The fram ework consist s of t hree pillars as follows:
o
o
o
Pillar 1 ( Minim um Capit al Requirem ent ) deals wit h t he required m inim um capit al t hat
each bank m ust provide t o cover credit , m arket and operat ional exposures.
Pillar 2 ( Supervisory Review Process) est ablishes t he supervisory review process
aim ed at ensuring an adequat e level of bank capit al t o cover t he full scope of bank
risks.
Pillar 3 (Mar ket Discipline) addresses m arket discipline and t he specifics of m inim um
lim it s of public disclosure.
I . Pilla r 1 - M in im u m Capit a l Re qu ire m en t
Pillar 1 est ablishes t he m inim um capit al requirem ent in relat ion t o credit risk, m arket
risk and operat ional risk. I n Basel I I , t he required level of bank capit al is at least 8% of
risk - weight ed asset s. Wit hin t his cont ext , capit al is divided int o several cat egories:
o
o
o
Tier 1 capit al, i.e. t he m ost basic level of capit al consist ing of shares plus noncum ulat ive preferent ial shares and reserves, subt ract ed by goodwill. Tier 1 capit al
m ust com prise at least 50 percent of bank capit al.
Tier 2 capit al, consist ing of asset revaluat ion value, general reserves, hybrid capit al
inst rum ent s and subordinat ed loans. This t ier m ay not exceed 50 percent of capital
Tier 3 capit al, was added in t he 1996 Capit al Accord Am endm ent , but is used only t o
cover t he port ion of t he bank capit al requirem ent allocat ed t o m arket risk. This
cat egory consist s of special t ypes of short- t erm subordinat ed loans.
I .1 . Cre dit Risk
Basel I I allows a financial inst it ut ion t o calculat e credit risk for com pliance wit h capit al
regulat ions by one of t he following t wo m et hods:
o Under t he St andardised Approach ( SA) , t he bank uses a list of risk weightings t o
calculat e t he credit risk for it s asset s. The risk weight ings are linked t o rat ings issued
for t he governm ent , financial inst it ut ions and com panies by an ext ernal rat ing
agency.
o The I nt ernal Rat ing Based Approach ( I RB) allows banks t o use t heir own int ernal
m odels for count erpart ies and exposures. This allows for m ore specific different iat ion
of risk am ong various exposures, producing a level of capit al m ore com m ensurat e t o
risk.
Cre dit Risk—St a n da rdised Approa ch ( SA)
Under t his approach, t he bank allocat es cert ain risk weight ings for each cat egory of
asset s and off-balance sheet it em s t o arrive at a t ot al figure for risk- weight ed asset s as
follows:
Risk- W eigh t e d
w eigh t ing
Asse t s
=
Tot a l
e x posur es
x
r isk
11
Allocat ions for each risk weight ing are based on general debt or cat egories ( governm ent ,
bank or corporat e) , which subsequent ly classified furt her according t o rat ings issued by
an ext ernal credit rat ing agency. The st andardised approach prescribes risk weight ings
based on differences in t he nat ure of t he asset s and ext ernal credit rat ings t o produce a
m ore risk- sensit ive result in com parison t o t he current Accord. The risk weight ings for
t he governm ent , ot her banks and corporat e exposures are different iat ed according t o t he
ext ernal credit rat ings. A 100 percent risk weight ing produces a capit al charge at 8% of
t he exposure value. Sim ilarly, a 20% risk weight ing produces an equivalent capit al
charge of 1.6% ( 20% x 8% ) .
Ot her risk weight ings have also been est ablished according t o differences in t he nat ure
of exposure. Exam ples of risk weight ings for t hese cat egories in use are:
-
35% for exposures t o resident ial housing com plying wit h st rict prudent ial crit eria;
-
75% for ret ail exposures ( loans t o sm all and m edium ent erprises m eet ing cert ain
crit eria enabling t hem t o be t reat ed as ret ail businesses) ;
-
100% for exposures t o com m ercial propert ies, wit h lim it ed exem pt ions under
certain conditions;
-
150% for high risk exposures, such as loans past due; and
-
350% for securit ised com ponent s rat ed BB+ and BB-.
Cre dit Risk—I n t e r na l Ra t in g Ba se d Appr oach ( I RB)
The I RB approach recognises t hat banks are cust om arily bet t er inform ed of t heir debt ors
t han a rat ing agency. This approach enables a bank t o apply m ore precise
different iat ions for each risk in com parison to t he seven risk cat egories ( 0% , 20% , 35% ,
50% , 75% , 100% and 150% ) in t he st andardised approach.
There are t wo approaches used in t he I RB, bot h of which are based on st rict
m easurem ent st andards and m et hodology and require supervisor approval:
-
Fou n da t ion I RB – t he bank calculat es probability of default ( PD) for each debt or
and t he supervisor provides ot her input , such as loss given default ( LGD) and
exposure at default ( EAD) .
-
Advan ce d I RB – in addit ion t o PD, t he bank includes ot her input s such as EAD, LGD
and m at urity ( M) . St rict er requirem ent s apply for using t his approach in com parison
t o foundat ion I RB.
Maj or param et ers in t he I RB approach:
- Probability of Default is t he likelihood t hat a debt or will default on obligat ions. All
banks m ust provide an int ernal m odel of PD for each debt or cat egory.
- Loss Given Default ( LGD) is t he est im at ed percent age of loss t hat would occur in t he
event of a debt or's default .
- Exposure at Default ( EAD) is t he est im at ed exposure t o a part icular debt or in t he
event of default .
- Mat urit y ( M) is t he effect ive t enor ( in years) of a bank exposure.
Asse t Ca t e gor ies in t h e I RB Appr oach
-
Corporat e Exposures – debt liabilit ies owed by com panies or arising from
part nerships or ownership. This cat egory is divided int o five sub- assets: proj ect
financing, purchase financing, com m odit y financing, incom e- generat ing real est at e
and high volat ilit y com m ercial real est at e.
-
Bank Exposures – exposures t o banks and securit ies com panies.
12
-
Governm ent Exposures – exposures t o t he governm ent , t he cent ral bank, public
sect or ent it ies and MDBs.
-
Ret ail Exposures – ret ail loans including loans t o individuals and sm all- scale
businesses, credit card operat ions, working capit al loans, hom e m ort gages and fixed
inst alm ent loans. Basel I I ident ifies t wo sub- cat egories: exposures guarant eed by
resident ial propert y and ret ail exposures m eet ing cert ain qualificat ions, including
ot her ret ail credit .
-
Equit y Exposures – ownership int erest s in com panies, part nerships and ot her
corporate business.
I n ce n t i v e s
The capit al rules are designed t o encourage banks t o shift from t he
st andardised approach t o t he I RB and from Foundat ion I RB t o
Advanced I RB. By swit ching t o a m ore advanced approach, m any
banks will benefit from reduced capit al allocat ion under t he capit al
rules as a result of t he m ore accurat e linkage bet ween capit al and risk.
Nevert heless, t he possibilit y rem ains t hat bank port folios are on
average higher risk and t he I RB approach dem ands a higher st andard
t han t he st andardised approach.
M it igat ion of Cre dit Risk
A lender can m it igat e credit risk if a debt or provides collat eral or a t hird party
underwrit es t he debt or’s obligat ions or t he bank buys credit prot ect ion, for exam ple
t hrough credit derivat ives, or by ot her m eans. Com pared t o t he Accord 88, Basel I I
provides for broader recognit ion of credit risk m it igat ion t echniques. Basel I I allows
banks t o recognise t he following form s of collat eral:
- Cash
- Designat ed securit ies issued by t he governm ent , public sect or ent it ies, banks,
com panies and securit ies com panies
- Designat ed negot iable equit ies
- Designat ed m ut ual funds
- Gold
For banks using t he st andardised approach t o calculat e credit risk, Basel I I offers t wo
possible m et hods for credit risk m it igat ion:
-
The sim ple approach, which enables
g
uarant eed claim s t o be assigned a risk
weight ing against t he collat eral inst rum ent , subj ect t o a m inim um lim it of 20% .
-
The com prehensive approach, focused on t he cash value of collat eral. This approach
uses t he haircut t o calculat e volat ilit y of collat eral value. This m ay be t he st andard
haircut as det erm ined by t he Basel Com m it t ee or an est im at e of collat eral volat ility
prepared by t he bank.
I f a bank is approved for use of an int ernal m odel, t he opt ions of t he sim ple approaches
described above are not available. I n t he case of banks using t he I RB approach, t he LGD
com ponent is also adj ust ed t o reflect t he benefit of using collat eral t o reduce losses.
A s s e t S e cu r i t i s a t i o n
Securit isat ion is a t echnique em ployed by banks t o t ransfer risk while raising liquidit y.
Tradit ionally, bank asset s are pooled and t hen sold by issuing securit ies guarant eed by
t hat pool of asset s. I n Basel I I , banks m ust use t he securit isat ion fram ework in
13
calculat ing t heir capit al requirem ent s against exposures arising
securit isat ion and synt heses or sim ilar st ruct ures wit h t hese feat ures.
from
t radit ional
Because of t he m any different m et hods of securit isat ion, t he det erm inat ion of t he capit al
required t o cover securit isat ion exposures m ust be based on econom ics subst ance over
form . The sam e principle also applies t o supervisors, who m ust give great er em phasis t o
econom ics subst ance in det erm ining whet her t he exposure fit wit hin t he securit isat ion
fram ework for calculat ing bank capit al adequacy.
I n securit isat ion, t he bank m ay act as t he original credit or or invest or for t he securit ised
asset s. I n eit her of t he t wo cat egories, t he bank role can vary widely. What ever t he
form , Basel I I st resses t hat banks m ust allocat e capit al t o cover various form s of
securit isat ion.
I . 2 . M a r k e t R i sk
On 1 January 1998, banks in tGhe - 10 count ries were
required t o allocat e capit al t o cover m arket risk ( as
st ipulat ed in t he m arket risk am endm ent t o t he Basel
Accord) . The bank capit al requirem ent for m arket risk is
det erm ined by t wo m et hods.
The first is t he st a ndar dise d a pproach, which applies a building block approach for
int erest rat e and equit y inst rum ent- relat ed t ransact ions. This approach different iat es
bet ween calculat ion of capit al charges for specific risks and general m arket risk.
The second is t he in t er n a l m odel a pproa ch, which enables banks t o use int ernal
m et hods com plying wit h t he qualit at ive and quant it at ive crit eria det erm ined by t he Basel
Com m it t ee, subj ect t o approval from t he supervisory aut hority. This approach set s
capit al charges at a higher level t han t he previous day's VaR or t he average daily VaR for
60 working days m ult iplied by t hree m inim um fact ors. Banks m ust calculat e t he VaR on
t he basis of daily value wit h
-
one- t ailed confidence int erval of 99%
-
10- day m inim um holding period
-
one- year m inim um observat ion period.
The int ernal m odel used by t he bank m ust accurat ely cover cert ain risks relat ed t o
opt ions and opt ion-like inst rum ent s.
14
I . 3 . O p e r a t i o n a l R i sk
The Basel Com m it t ee defines operat ional risk as t he “ risk t hat originat es direct ly or
indirect ly from inability or failure of int ernal processes, persons and syst em s, as well as
from ext ernal event s." Three approaches m ay be used t o det erm ine t he capit al charges
for operat ional risk:
o
The Ba sic I ndica t or Approa ch calculat es capit al charges for operat ional risks on
t he basis of a cert ain percent age ( alpha fact or) of gross incom e used as an est im at e
for bank risk exposures. Under t his approach, t he capit al t hat m ust be allocat ed by
t he bank t o cover losses arising from operat ional risks equals a cert ain percent age of
average gross incom e over a t hree year period.
o
The St a nda r dise d Approach requires an inst it ut ion t o disaggregat e it s act ivit ies
int o eight st andard business lines. The capit al charge for each business line is
calculat ed by m ult iplying it s gross incom e by a cert ain predet erm ined const ant ( bet a
fact or) t hat is different for each business line.
o
I n t he Adva n ce d M e asu re m en t Appr oach, t he calculat ion of t he capit al
requirem ent is t he sam e as t he risk m easurem ent generat ed by a m odel for
m easuring operat ional risk developedi nt ernally by t he bank. The bank m ust m eet
t he qualit at ive and quant it at ive crit eria st ipulat ed in Basel I I and m ust have approval
from t he supervisory aut horit y.
Ca l cu l a t i o n o f Ca p i t a l A d e q u a cy
Basel I I requires banks t o allocat e capit al at 8% of risk-weight ed asset s, calculat ed
according t o t he following form ula:
For exam ple, a bank has USD10 billion in risk-weight ed asset s, a USD300 m illion capit al
charge for m arket risk and a USD100 m illion capit al charge for operat ional risk. The
m inim um capit al requirem ent for t he bank is:
= [ USD10 billion + 12.5 x ( USD300 m illion + USD100 m illion) ] x 8% = USD1.2 billion
This m eans t hat t he bank m ust allocat e capit al of at least USD1.2 billion.
I I . P i l l a r 2 - T h e S u p e r v i so r y R e v i e w P r o ce s s
Pillar 2 focuses on t he review process wit hin t he supervisory fram ework t hat is aim ed at
ensuring t hat banks m aint ain levels of capit al com m ensurat e t o t heir risk profile. The
supervisory review process seeks t o ensure t hat banks calculat e t heir capit al adequacy
t o cover t he full scope of risk and supervisors assess and t ake any necessary act ions t o
respond t o t he capit al calculat ions m ade by t he bank.
The supervisor m ay ask t he bank t o set aside capit al in excess of t he m inim um capit al
rat io or t ake rem edial m easures such as st rengt hening of risk m anagem ent or ot her
act ions. I f a higher
r at io becom es necessary, t he supervisor m ay int ervene if bank
capit al is below t hat lim it .
15
Pillar 2 requires banks t o conduct regular st ress t est ing t o
est im at e how m uch capit al would be required under crisis
condit ions. The bank and t he supervisor m ust use t he t est result s
t o ensure t hat bank capit al is at an adequat e level.
Pillar 2 encom passes four key principles:
o
Banks m ust have a process for calculat ing overall capit al adequacy based on t heir
risk profile and a st rat egy for m aint aining t heir level of capit al;
o
The supervisor m ust review and evaluat e t he st rat egy and capital adequacy
calculat ions m ade int ernally by t he bank and t he abilit y of t he bank t o m onit or and
ensure com pliance wit h t he prescribed capit al rat io;
o
The supervisor m ay order a financi al inst it ut ion t o operat e above t he prescribed
capit al rat io and has t he aut horit y t o order a bank t o allocat e capit al above t he
m inim um lim it ; and
o
The supervisor m ay int ervene at an early st age t o prevent decline in bank capit al
below t he m inim um lim it and t o ensure t hat t he bank t akes rem edial m easures if t he
level of capit al is not m aint ained or sinks t o it s form er level.
I I I . P i l l a r 3 : M a r k e t D i s cl o su r e
Pillar 3 requires banks t o disclose adequat e inform at ion for m arket
players t o underst and t he risks involved in t he banks. This enables
m arket players t o assess t he key inform at ion on t he scope of risk,
capit al, risk exposures, risk m easurem ent process and bank capit al
adequacy.
I n som e cases, disclosure serves as a special crit eria in Pillar 1 enabling t he bank t o
apply a lower risk weight ing and/ or use a part icular m et hodology. This is expect ed t o
operat e as a form of direct sanct ion because of failure t o com ply wit h t he disclosure
requirem ent s ( e.g., not perm it t ed t o apply lower risk weight ings or use cert ain
m et hodologies) . Pillar 3 also discusses t he issues of t he role of significant inform at ion,
frequency of disclosure and issues regarding propriet ary inform at ion.
16
F r e q u e n t l y A sk e d Q u e st i o n s
1 . W h at is BI S?
The Bank for I nt ernat ional Set t lem ent s ( BI S) is an int ernat ional organisat ion t hat
prom ot es int ernat ional m onet ary and financial cooperat ion and operat es as t he bank for
cent ral banks. To m eet it s responsibilit ies, BI S carries out a num ber of key act ivit ies.
o As a forum for prom ot ing discussions and policy analyses am ong cent ral banks
and wit hin t he int ernat ional financial syst em .
o As a research cent re for econom ics and m onet ary policy
o As a leading part ner for cent ral banks in financial t ransact ions
o As an agent or represent at ive for cent ral bank dealings in int ernat ional financial
act ivit ies.
2 . W h at is t he Base l Com m it t e e on Ba n k in g Su pe r vision ?
The Basel Com m it t ee on Banking Supervision ( BCBS) , bet t er known as t he Basel
Com m it t ee, was est ablished in a volunt ary act ion by t he m onet ary aut horit ies of t he G10 count ries and a num ber of ot her nat ions. The com m it t ee has no official reach as an
int ernat ional supervisory aut horit y and it s decisions are never int ended t o be legally
binding.
The Basel Com m it t ee was set up by cent ral bank governor s from t he G- 10 count ries at
t he end of 1974 and convenes four t im es a year. These count ries are represent ed by
t heir cent ral banks and also t he aut horit ies responsible for supervision of t he banking
business if not under t he powers of t he cent ral bank. The Com m it t ee develops policy
guidelines t hat nat ional supervisory aut horit ies m ay decide on as appropriat e t o t he
supervisory policy t o be im plem ent ed by t he individual count ry.
The Basel Com m it t ee form ulat es supervision st andards and guidelines gof a eneral
nat ure and issues st at em ent s wit h broad applicat ion on best pract ices. This is int ended
t o enable each aut horit y t o t ake m easures for applying t hese st andards wit hin a legal
and regulat ory fram ework appropriat e t o t he individual count ry’s syst em .
The m ost im port ant out put of t he Basel Com m it t ee is t he ruling on m inim um capit al
st andards for banks worldwide. The Basel Capit al Accord was first announced in July
1988 and was im plem ent ed by all m em bers of t he Basel Com m it t ee in 1992. Alt hough
t he accord was init ially t arget ed at int ernat ionally act ive banks, it ult im at ely gained
broad int ernat ional accept ance am ong banks and supervisory aut horit ies. More t han 100
count ries around t he world have now adopt ed t he Basel Accord.
3 . W h at a r e t h e diffe re n ce s be t w e en Ba se l I a n d Ba se l I I ?
Basel I I builds on t he basic st ruct ure of t he 1998 accord ( Basel I ) t o det erm ine capit al
requirem ent s in relat ion t o credit and m arket risk and t o develop a m ore risk- sensit ive
capit al fram ework. This has been achieved by adj ust ing capit al requirem ent s t o credit
risk and also by int roducing changes in t he m et hod for calculat ing capit al t o cover
exposures from risk of losses at t ribut able t o operat ional failures.
Even so, in broad t erm s t he Basel Com m it t ee has ret ained t he aggregat e level of t he
m inim um capit al requirem ent and est ablishes incent ives for applicat ion of t he m ore
advanced risk- sensit ive approaches wit hin t he Basel I I fram ework. Basel I I com bines t he
m inim um capit al requirem ent wit h supervisory review and m arket discipl ine t o prom ot e
im provem ent in risk m anagem ent .
17
4 . W h at a r e t h e obj e ct ives of t h e Ba se l Ca pit al Accor ds?
The obj ect ives of Basel I and Basel I I are essent ially t he sam e. First , t he Basel I
fram ework was designed t o im prove soundness and st abilit y of t he int ernat ional banking
system . Secondly, t he Basel I fram ework was expect ed t o creat e a level playing field
am ong different count ries wit h a high level of consist ency in percept ions t o reduce
sources of unfair com pet it ion am ong int ernat ionally act ive banks. I n t he Basel I I
fram ework, t he Com m it t ee believes t hat t he changes t o t he exist ing approaches will
encourage t he banking indust ry t o use t he im proved risk m anagem ent m et hods.
5 . I s it com pulsor y for a n a t ion t o im ple m e n t Ba se l I I ?
No count ry is required t o im plem ent Basel I I . No policy issued by BI S is legally binding
on any count ry. For t his reason, im plem ent at ion of Basel I I is a decision at t he individual
count ry level, t aking int o account t he st at e of preparedness of t hat count ry's banking
system .
6 . W h a t im pact does Ba se l I I h a ve on a na t ion ?
When a count ry im plem ent s Basel I I , t his act ion is expect ed t o st rengt hen financial
syst em st abilit y by prom ot ing advancem ent in risk m anagem ent and capit al adequacy in
t he banking syst em . Furt herm ore, Basel I I is also expect ed t o:
o I m prove corporat e governance and risk m anagem ent
o Creat e m ore efficient capit al allocat ion and build a robust capit al st ruct ure
o St rengt hen st andards of t ransparency
o I m prove bank supervision in regard t o processes and im plem ent at ion.
7 . Ca n Ba se l I I be im ple m e n t e d in I n don esia?
Yes. Basel I I is a broad policy fram ework consist ing of a set of best pract ices applied
worldwide. The concept s in Basel I I can t herefore be applied in any count ry, including
I ndonesia.
8 . W h y m u st Ba sel I I be im ple m en t ed in I n done sia?
Basel I I prescribes a m ore risk- sensit ive fram ework for calculat ion of t he capit al
requirem ent . These capit al adequacy calculat ions also t ake int o account t he various risks
involved on a m ore com prehensive scale. This will encourage banks t o im prove t heir
risk m anagem ent in order t o obt ain a m ore precise value of econom ic capit al. I t will also
encourage supervisors and m arket players t o play a great er role in financial syst em
st ability.
9 . I s it a ppr opr iat e for I n don esia t o im ple m e n t Ba se l in t h e n e a r fu t u r e ?
Yes. Since t he int roduct ion of Basel I , t he I ndonesian banking syst em has undergone far
reaching changes from :
o Globalisat ion
o Developm ent s in t echnology
o I nnovat ions in t he financial world
Furt herm ore, Basel I focuses only on credit risk and m arket risk, t hereby sim plifying
assum pt ions of risks in a way t hat will not prot ect bank soundness.
Basel I I provides a fram ework capable of m aint aining t he soundness and st abilit y of t he
banking syst em t hrough:
o St rengt hening of int ernal processes
o Prom ot ing t he use of m ore advanced and sophist icat ed risk m anagem ent
pract ices
o Risk m easurem ent s m ore accurat ely depict ing t he t rue level of risks carried by
t he bank
o I m provem ent s in t ransparency.
18
1 0 . W h a t a pproa ch w ill be use d in I n don e sia ?
Bank I ndonesia will int roduce t he st andardised, int ernal rat ing- based and advanced
approaches. These approaches will be phased in over t im e. The decision on t he approach
t o be used will be m ade by individual banks wit h approval from t he supervisor.
1 1 . M ay ban ks choose t h e a ppr oach t h ey use ?
Yes, banks m ay choose t he approach t hey wish t o use. However, t he use of any
approach ot her t han t he st andardised approach m ust be approved by t he bank
supervisor. I f a bank has already used t he int ernal rat ing based or advanced approach, it
will not be perm it t ed t o replace t he approach in use wit h t he st andardised approach
wit hout approval from t he bank supervisor.
1 2 . W ill ba nk s be r e qu ire d t o u se t h e I n t e r na l Ra t in g- Ba se d or Adva n ce d
a pproach?
No, banks are not required t o use eit her t he int ernal rat ing- based or t he advanced
approach. The decision about which approach t o use is ent irely at t he discret ion of t he
individual bank. I f a bank is unable t o im plem ent an int ernal rat ing- based or advanced
approach, it will be encouraged t o rem ain wit h t he st andardised approach.
19
GL O S S A R Y
-
Pillar 1: Rules est ablishing a m inim um rat io of capit al t o risk- weighted asset s.
-
Pillar 2: The supervisory review pillar, requiring supervisors t o perform a qualit at ive
review of t he capit al allocat ion t echniques used by t he bank and com pliance wit h
relevant st andards.
-
Pillar 3: Disclosure requirem ent s t hat facilit at e m arket discipline.
-
I nt ernal Rat ing: Result of a bank’s risk m easurem ent of it s credit port folio.
-
Ext ernal Credit Rat ing: Rat ing issued by an external rat ing agency.
-
Consolidat ion: Measurem ent of bank risk encom passing t he ent ire business group
linked to t he bank.
-
Operat ional Risk : Risk arising direct ly or indirect ly from t he inabilit y or failure of
int ernal processes, persons or syst em or from ext ernal event s.
-
Credit Risk: Risk of loss arising from default by a debt or or count erpart y.
-
Market Risk: Risk of loss arising from a t rading posit ion when prices undergo change.
-
Mit igat ion of Credit Risk : A set of t echniques enabling a bank t o prot ect part of it s
I m ple m e n t a t ion of Ba se l I I in I n don e sia
Ba n k I n don e sia
D ir e ct or a t e of Ba n k in g Re se a r ch a n d Re gu la t ion
1
Ta ble of Con t e n t s
Fo r ew o r d
Bas el I I at a Gl an ce
Ban k Cap i t al
Th e Cap i t al A d eq u acy Rat i o ( CA R)
D ef i n i t i on o f Reg u l at o r y Cap i t al
Mi n i m u m Cap i t al Rat i o
Ri sk W ei g h t i n g s
S
Et ruct ure of Basel I I
Bas el Cap i t al A cco r d
Pi l l ar 1 —D ef i n i t i o n o f Capi t al , Mi t i g at i o n o f Cr ed i t Ri sk
Mar k e t Ri sk , Op er at i o n al Ri sk
Pi l l ar 2 —S u p er v i so r y Rev i ew Pr o ces s
Pi l l ar 3 —Mar k e t D i scl o su r e
Fr eq u en t l y An sw er ed Qu est i o n s
Gl o ssar y
2
Forew ord
The purpose of t his book is t o help readers underst and t he im port ance of capit al, not
only for individual banks, but also in safeguarding financial syst em st abilit y. Because of
t his vit al role, t he regulation of bank capit al is guided by int ernat ional st andards issued
by t he Basel Com m it t ee on Banking Supervision. The Basel I st andard, init ially adopt ed
in 1988, has undergone num erous changes over t im e in response t o t he rapid
developm ent of financial m arket inst rum ent s. Ult im at ely, agreem ent was reached on a
m ore risk sensit ive st andard for calculat ion of bank capit al known as Basel I I .
This sim ply- worded book is designed t o inform readers of t he process of change in
capit al st andards and t he background t o t he issuance of Basel I I , in which bank capit al
adequacy is linked t o t he risk profile of t he individual bank.
This book does not delve int o t he in dept h t echnical det ail on each aspect of Basel I I , but
rat her is aim ed m ore at present ing a com m on line of t hought for Basel I I , t hat of
im proving bank risk m anagem ent in order t o provide bet t er assurance of financial
syst em st abilit y, which will ult im at ely support econom ic growt h.
Jakart a, Sept em ber 2006
3
Basel I I at a Gla nce
I m pr ove d St a n da r d for Ca pit a l Ade qu acy
A bank provides an int erm ediat ion funct ion for funds received from cust om ers. Failure of
a bank will result in widespread im pact affect ing ret ail and inst it ut ional cust om ers who
hold funds at t he bank. This could t rigger m ult iplier im pact s on
t
he dom est ic and
int ernat ional m arket . The im port ance of t he banking role dem ands proper regulat ion, in
which t he prim ary obj ect ive is t o m aint ain cust om er confidence in t he banking syst em .
An essent ial part of t he regulat ory fram ework for t he banking syst em involves t he
regulat ions governing bank capit al, which funct ions as a buffer against losses.
I n view of t he im port ance of capit al t o banks, BI S issued a capit al fram ework concept
m ore com m only known as t he 1988 accord ( Basel I ) . This syst em was designed as a
fram ework for m easurem ent of credit risk and est ablished a m inim um capit al st andard at
8% . The Basel Com m it t ee designed Basel I as a sim ple st andard requiring banks t o
disaggregat e t heir exposures int o broader cat egories reflect ing debt or sim ilarit ies.
Exposures t o cust om ers of t he sam e t ype ( such as exposures t o all corporat e cust om ers)
are subj ect t o t he sam e capit al requirem ent s wit hout t aking account of differences in
loan repaym ent capacity and specific risks associat ed wit h t he individual cust omer.
More t han a decade lat er, prom pt ed by t he evolut ion of banking worldwide and t he
reality t hat t he best m et hod for calculat ing, m anaging and m it igat ing risks would be
different from bank t o bank, t he Basel Com m it t ee em barked on t he init iat ive for revision
of Accord 1988. The growing diversit y and sophist icat ion of product s in t he banking
syst em led BI S t o int roduce im provem ent s t o t he capit al fram ework in t he 1988 accord
wit h t he launching of a new capit al concept known as Basel I I . The first proposal w as
released in 1999 and was slat ed for im plem ent at ion at end- 2006. The revised capit al
accord—Basel I I —is a com prehensive agreem ent t hat est ablishes a spect rum of m ore
risk - sensit ive capit al allocat ion and incent ive for im provem ent s in t he quality of risk
m anagem ent at banks. This was achieved by adj ust ing capit al requirem ent s t o credit risk
and operat ional risk, and int roducing changes in calculat ion of capit al t o cover exposures
t o risks of losses caused by operat ional failures. I n addit ion t o t he calculat ion of
m inim um bank capit al, Basel I I also provides for a supervisory review process t o ensure
t hat banks m aint ain a level of capit al com m ensurat e t o t heir risk profile and prom ot es
m arket discipline t hrough disclosure requirem ent s.
BASEL II
MARKET
DISCIPLINE
SUPERVISORY
REVIEW
PROCESS
MINIMUM
CAPITAL
REQUIREMEN
3 PI LL ARS
Providing a flexible, risk-sensitive capital
mana gement f ramework
The obj ect ive of Basel I I is t o st rengt hen t he securit y and soundness of t he financial
syst em by reinforcing t he em phasis on risk- based calculat ion of capit al, t he supervisory
review process and m arket discipline. The Basel I I Fram ework is based on a forward-
4
looking approach t hat enables im provem ent s and changes t o be m ade over t im e. I n t his
way, t he Basel I I fram ework is able t o keep pace wit h changes in t he m arket place and
developm ent s in risk m anagem ent .
At first glance, Basel I I involves various com plexit ies and precondit ions t hat are difficult
for banks t o m eet. However, t he ext ra effort is well j ust ified in view of t he benefit s t o
banks from m ore econom ic use of capit al in covering t heir risks. Banks also benefit from
t he int ernat ional recognit ion of t he Basel I I st andards, which enables a bank int ending t o
operat e globally t o be readily accept ed on t he int ernat ional m arket , provided t hat t hese
standards are m et .
M a x im isin g t h e Be n efit s of Ba sel I I
Basel I I calculat es t he capit al requirem ent according t o t he bank risk profile and cont ains
incent ives for im provem ent in risk m anagem ent wit hin t he banking syst em . By using
various approaches t o m easure credit risk, m arket risk and operat ional risk, t he result
obt ained is m ore risk- sensit ive allocat ion of bank capit al. I n Basel I I , t he calculat ion of
bank capit al is prescribed in Pillar 1 – t he Minim um Capit al Requirem ent . The alt ernat ive
approaches can essent ially be aggregat ed int o t wo m aj or groups: t he st andardised
m odels t hat apply t o all banks and t he m ore sophist icat ed int ernal m odels developed as
appropriat e t o t he nat ure of business and risk profile of t he individual bank.
A com parison bet ween t he t wo m aj or approaches reveals t hat int ernal m odels can
generally be expect ed t o generat e m ore precise capit al adequacy calculat ions
appropriat e t o t he risks faced by t he bank. This will offer banks an incent ive t hat is
expect ed t o prom ot e sust ained effort s t o build t he qualit y of risk m anagem ent . I n t his
way, over t im e, banks will m axim ise t he benefit of t he m ore sophist icat ed approaches in
calculat ing t heir capit al requirem ent .
Minimum Capital Ratio = 8% =
Capital (Tier 1 + Tier 2 + Tier 3)
Risk-Weighted Assets
Market Risk
Credit Risk
Operational
Risk
Risk of loss from
on and off balance
sheet positions
from changes in
market factors
(interest rates and
exchange rates)
Risk of loss from
default by
debtors/
counterparties
Risk of loss directly
or indirectly caused
by weaknesses or
failures in internal
processes, human
resources and
systems and by
external events
Significant
Changes
Additional
Risk
No Significant
Changes
5
I n assessing bank capit al adequacy, it is not only necessary t o allocat e capit al on t he
basis of Pillar 1, but also capit al t o ant icipat e losses from ot her risks, such as liquidity
risk, st rat egic risk, int erest rat e risk in t he banking book and ot her risks. This approach
is capt ured in Pillar 2, t he Supervisory Review Process, and is referred t o as t he
I ndividual Capit al Adequacy Assessm ent Process ( I CAAP) . I t will pose an im port ant
challenge for banks and supervisors. Building of supervisor com pet ence and capacit y will
be essent ial, as also t he support of t he regulat ory fram ework for bank supervision. Wit h
t im e, supervisors will becom e effect ive in t he assessm ent of risks ot her t han t hose
covered in Pillar 1 and m ay even order banks t o add t o t heir capit al if bank capit al is
deem ed inadequat e.
Furt herm ore, t he act ive public role in scrut iny of banks is seen as crucial. From t he
beginning, t he public will also be expect ed t o assess bank risks and ascert ain t he level of
capit al adequacy as envisaged in Pillar 3 – Market Discipline. The synergy of t he t hree
Pillars in Basel I I is int egral t o building a sound and st able banking indust ry and financial
system .
I m pa ct of Ba sel I I on t h e Re silien ce of t h e Ba n k in g Syst e m
1 . W ill Base l I I ca u se ban k CAR t o drop be low t he 8 % m inim um ?
Bank I ndonesia is now working t oget her wit h a num ber of banks on a periodical
st udy of quant it at ive im pact t o assess t hec onsequences of Basel I I on bank capit al.
For t his reason, the im pact of Basel I I should be exam ined on an individual basis. I t
is necessary t o perform assessm ent s and im prove t he effect iveness of risk
m anagem ent from an early st age in order t o gain m axim um advant age from t he
available incent ives. A drop in t he CAR could well occur for banks wit h a higher risk
profile. However, banks whose credit port folios are dom inat ed by ret ail loans and
hom e m ort gages will see a reduct ion in t heir capit al requirem ent because of t he
lower risk weight ings t hat will apply t o ret ail loans and hom e m ort gages.
2 . W ill Ba sel I I be im ple m en t ed for a ll com m e rcial ba n k s?
The focus of Basel I I in I ndonesia is developm ent and im provem ent in risk
m anagem ent wit hin t he nat ional banking syst em . This was set out in Bank I ndonesia
Regulat ion No. 5/ 8/ PBI / 2003 dat ed 19 May 2003 concerning Applicat ion of Risk
Managem ent for Com m ercial Banks. These m easures will apply t o all banks
regardless of size, given t hat t he risk m anagem ent cult ure should becom e st andard
pract ice in t he banking business. Survey shows t hat banks would prefer Basel I I t o
be im plem ent ed across t he board. The m ain reason is t o m inim ise t he negat ive
im pact on com pet it ion t hat would arise from different iat ions by ability and readiness
of banks t o im plem ent and develop risk m anagem ent and t he associat ed
infrast ruct ure. Furt herm ore, all banks in I ndonesia will be able t o apply t he st andard
approaches in Basel I I .
3 . Could Ba se l I I h a m pe r t h e in t e r m e dia t ion pr oce ss?
Basel I I is not int ended t o ham per t he int erm ediat ion process current ly in operat ion
in t he banking syst em . At t he m acro level, it also does not seek t o reduce t he
dom inant role of t he banking syst em in financing econom ic act ivit ies. The overall
t hrust of t he approaches put forward in Basel I I is int ended m ore as an effort t o
reposit ion and redefine what has been achieved by t he banking syst em , wit h focus on
im proving risk m anagem ent .
I n regard t o t he int erm ediary funct ion, Basel I I is not a m echanical capit al regi m e
wit h no room for t olerance. Room for flexibilit y is assured by a num ber of nat ional
discret ion clauses. While Basel I I is expect ed t o see reduced exposures t o cert ain
6
sect ors ( e.g. because of t he use of rat ings in lending t o corporat e ent it ies) , on t he
ot her hand it will also encourage increased exposures t o ot her sect ors, such as ret ail
lending ( e.g. sm all- scale business credit , personal loans and so on) and housing
m ort gages t hrough reduced risk weight ings. I t is underst ood t hat t his shift in
exposures will bring som e shock t o banks, debt ors and t he econom y as a whole.
Even so, t his effect is not expect ed t o last long, and will be no m ore t han a fine
t uning cust om ary t o any econom y.
4 . W h at w ill be t h e im pa ct for ba nk s cu rr e nt ly w ork ing on r a ising t h eir ca pit a l
for t h e im ple m e n t a t ion of t h e I n don esian Ba nk ing Ar ch it e ct u r e?
Raising addit ional capit al for t he purposes of t he I ndonesian Banking Archit ect ure will
not in it self provide t he m eans for a bank t o achieve full com pliance wit h Basel I I .
However, a n adequat e capit al base will enable a bank t o develop t he hum an
resources and inform at ion t echnology capabilit ies essent ial for Basel I I . I n t his way,
t he Rp 80 billion t ier 1 capit al requirem ent for com m ercial banks, t o be m et by t he
end of 2007, and t he Rp 100 billion requirem ent for t he end of 2010 will not only
expand t he econom y of scale in conduct ing operat ions, but also provide opport unit y
for t he bank t o st rengt hen it s risk m anagem ent capabilit ies for im plem ent at ion of
Basel I I .
5 . W h a t a r e t h e pr er e qu isit es for proper im plem e nt a t ion of Ba sel I I ?
Condit ions t hat m ust be sat isfied for proper im plem ent at ion of Basel I I include:
-
Applicat ion of risk m anagem ent pract ices in t he banking syst em as st ipulat ed
in Bank I ndonesia Regulat ion No. 5/ 8/ PBI / 2003 dat ed 19 May 2003
concerning Applicat ion of Risk Managem ent for Com m ercial Banks
-
Adj ust m ent s in account ing st andards in keeping wit h int ernat ional account ing
st andards ( I AS) , including but not lim it ed t o I AS 32 and I AS 39
-
Consolidat ed calculat ion of bank capit al t o cover com panies in t he sam e group
operat ing in t he financial sect or, wit h t he except ion of insurance com panies
-
Recognit ion of a rat ing agency t o enable obj ect ive rat ing of bank debt ors.
Roa dm ap for Basel I I in I n done sia: W h a t Ba n k I n don esia a n d t h e Ba nk ing
Syst e m M ust D o t o Pre pa re
Basel I I st at es t hat each supervisory aut hority m ust weigh priorit ies before adopt ing
Basel I I . I n im plem ent ing Basel I I , Bank I ndonesia is essent ially seeking t o st rengt hen
risk m anagem ent so t hat banks willb ecom e m ore resist ant t o dom est ic, regional and
int ernat ional shocks. Bank I ndonesia has developed a realist ic form at t o be followed in
t he im plem ent at ion of Basel I I t hat t akes account of t he current condit ion of t he banking
indust ry. For t his reason, t he default m ode for im plem ent at ion will be t o t ake t he
sim plest pat h, i.e. t he st andardised approach. This m eans t hat all banks will m ake
adj ust m ent s t o t heir capit al adequacy calculat ions on t he basis of t he Basel I I guidelines.
Basel I I also provides for nat ional discret ion, in which som e m at t ers are decided by t he
local supervisory aut horit y. Judgem ent s can t herefore be m ade for t he condit ion of t he
I ndonesian banking syst em and com plexit y of I ndonesia's banking product s.
As part of t he ongoing consult at ions on t he subst ance of Basel I I , including nat ional
discret ion, Bank I ndonesia has set up a working group t oget her wit h t he banking syst em
t o develop recom m endat ions on t he m ost appropriat e regulat ory fram ework. These
recom m endat ions will t hen be set out in a Consult at ive Paper ( CP) t o be dist ribut ed t o
st akeholders and especially banks in order t o invit e opinions, suggest ions and input s.
7
There have been widespread m isunderst andings am ong bankers t hat banks will be
required t o adopt m ore advanced approaches dem anding heavier invest m ent in
expensive I T and dat abases, a requirem ent t hat would obviously place banks under
financial st rain. I n principle, banks are given flexibilit y t o adopt m ore advanced
approaches, such as I RB, provided t hat t he necessary preparat ions in I T, hum an
resources and syst em s are com plet e and t he bank risk profile offers assurance t hat t he
use of a m ore advanced approach would offer benefit s for t he bank. I n t hese cases,
banks m ay apply t o Bank I ndonesia for approval. The BI supervisors will validat e t he
st at e of preparedness of t he bank before perm it t ing t he bank t o calculat e capit al
adequacy using int ernal m odels. Bank I ndonesia is now providing special t raining t o
bank supervisors who will becom e validat ors of m arket risk and validat ors of credit risk.
Use of Risk Calculation
Approach
PILLAR 1
Publish BI
Regulations
Parallel Run
(Standardised) 1) or
Validation Process
(Internal Model)
CAR
Method
Effective
Improvements
to Commercial
Bank Report
PILLAR 2
PILLAR 3
Other Risks 4)
Transparency
Online System
Issue BI
Regulations
CAR Method
Effective
Publish BI
Regulations
Q3/2007
Q1/2009
Q1/2009
Market Risk
Standardised 2)
Q3/2007
Q1/2008 – Q4/2008
Q1/2009
Q4/2008
Internal Model 3)
Q3/2007
Start Q3/2007
Q2/2008
Q2/2008
Q1/2009
Credit Risk
Standardised
IRBA 3)
Q3/2007
Q4/2009
Q1/2008 – Q1/2009
Start Q1/2010
Q1/2009
Q4/2010
Q4/2008
Q4/2010
Q1/2009
Q2/2011
Basic Indicator
Standardised 3)
Q3/2007
Q4/2009
Q1/2008 – Q1/2009
Start Q1/2010
Q1/2009
Q4/2010
Q4/2008
Q4/2010
Q1/2009
Q2/2011
AMA 3)
Q4/2009
Start Q1/2010
Q2/2011
Q4/2010
Q2/2011
Operational Risk
I m ple m e n t a t ion of Ba se l I I in Ot he r Coun t rie s
I n cont rast t o t he G- 10 count ries, non G- 10 nat ions do not com e under any deadline for
im plem ent at ion of Basel I I . This is consist ent wit h t he underlying nat ure of Basel I I ,
which does not const it ut e a legally binding docum ent im posing sanct ions on non com plying count ries. Furt herm ore, assessm ent of a count ry’s financial sect or st abilit y will
not be based on im plem ent at ion of Basel I I , but m ore on t hat count ry’s com pliance wit h
t he 25 B asel Core Principles for Effect ive Banking Supervision ( BCP) . For t his purpose,
I ndonesia has m ade st eady im provem ent s in com pliance with t he BCP in recent years.
I ndeed, t he sheer diversit y of preparat ions and policies m eans t hat each count ry will
follow a unique pat h in im plem ent ing Basel I I . The condit ion, st ruct ure and business
com plexity of t he banking syst em and quality of bank supervision are t he m ain fact ors
t hat will be t aken int o account in est ablishing t hese policies. I n t he Unit ed St at es, for
exam ple, t he advanced I RB ( A- I RB) will be adopt ed by only t he 10 leading banking
groups widely known for t heir int ernat ional operat ions. Ot her banks will apply a Basel I I
form at known as Basel 1A.
8
Ba nk Ca pit al
For banks, as for com panies in general, capi t al funct ions not only as t he m ain resource
for financing operat ions, but also provides a buffer against possible losses. Capit al also
helps t o m aint ain public confidence in t he abilit y of a bank t o operat e in t he
int erm ediat ion of cust om er funds.
The bank supervision aut horit y is responsible for ensuring a m inim um adequacy of bank
capit al by est ablishing rules concerning t his issue. Regulat ory Capit al is t he capit al
requirem ent prescribed by t he supervisory aut hority as a buffer against pot ent ial losses.
The requirem ent s applying t o Regulat ory Capit al are a key com ponent of bank
supervision and are reflect ed in t he definit ion of regulat ory capit al and t he capit al
adequacy rat io ( CAR) .
D e f i n i t i o n o f R e g u l a t o r y Ca p i t a l
A general definit ion of capit al was first int roduced in Basel I , t he first broad approach t o
capit al adequacy. This definit ion has rem ained unchanged and is ret ained in Basel I I .
The definit ion st at es t hat regulat ory capit al is divided int o t hree t iers. An it em m ay be
grouped int o one of t hese t iers, provided t hat it sat isfies cert ain crit eria. The definit ion of
regulat ory capit al set s out t he crit eria for cat egorisat ion as an elem ent of capit al, and
t hus ensures consist ency of capit al adequacy am ong different nat ions. This has
prom ot ed m ore com m on underst anding am ong banks in general and t he m ore
int ernat ionally act ive banks in part icular.
Under Basel I and Basel I I , regulat ory capit al is divided int o t hree levels or t iers of
capit al as follows:
o
Tier 1 capit al. This t ier c onsist s of inst rum ent s wit h t he great est capacit y t o absorb
losses arising at any t im e.
o
Tier 2 capit al. This t ier consist s of a broad m ix of equit y com ponent s and hybrid
capit al/ debt inst rum ent s. Tot al Tier 2 capit al is rest rict ed t o 100% of Tier 1 and is
divided int o t wo cat egories:
?
Upper Tier 2, rest rict ed t o 100% of Tier 1 capit al,
?
Lower Tier 2, rest rict ed t o 50% of Tier 1 capit al.
o
Tier 3 capit al was added in 1996 , and is used only t o m eet capit al requirem ent s for
m arket risk.
Th e Ca pit al Adequ a cy Ra t io ( CAR)
The obj ect ive of t his rat io is t o ensure t hat banks are capable of absorbing losses
incurred in t he course of t heir act ivit ies. The exist ing regulat ory rat io is t he 8%
m inim um . This links bank capit al t o t he risk weight ings of asset s held by t he bank.
Supervisor risk weight ing is t he percent age used t o convert t he nom inal value of credit
exposures t o a specific value reflect ing level of risk. The risk weight ing for each asset is
prescribed in a Bank I ndonesia regulat ion. The capit al t hat m ust be allocat ed t o cover
pot ent ial loss in relat ion t o t he exposures is obt ained by m ult iplying t he exposure value
by t he weight ing for t he asset s and t he m inim um capit al requirem ent ( i.e. 8% ) .
Som e banks have begun using capit al adequacy assessm ent approaches as a risk
m anagem ent funct ion. Banks will norm ally assess t he am ount of capit al required t o
cover loss up t o a cert ain level of probabilit y. The developm ent of t hese approaches has
9
been driven by evidence t hat capit al is a very cost ly resource for a bank. The bank m ust
t herefore have st rong incent ives t o m anage capit al as effect ively as possible. Since t he
m id-1990s, som e of t he world's largest and m ost sophist icat ed inst it ut ions have
developed various m easures of econom ic capit al and have specifically com bined t hese
wit h risk m anagem ent syst em s for m ore efficient m anagem ent of risks and capit al.
The obj ect ive of bank supervision is t o ensure t hat banks conduct t heir operat ions in line
wit h prudent , sound principles. To t his end, banks m ust m aint ain adequat e capit al and
reserves t o offset risks arising in t he course of business. The m ain principles of t he Basel
Com m it t ee on Banking Supervision ( BCBS) st at e t hat bank supervisors m ust est ablish a
safe and appropriat e level of m inim um capit al requirem ent for all banks. The ult i m at e
goal of all aut horit ies involved in bank supervision is t o prot ect t he st abilit y and
soundness of t he financial syst em . Since t he end of 1980, st andardised calculat ions of
bank capit al based on t he BCBS guidelines have com e int o widespread int ernat ional use
in support of t his goal.
Com pliance wit h t he m inim um capit al requirem ent ( or solvency rat io) is det erm ined by
t wo com ponent s as follows:
o The risk weight ings for bank asset s—i.e. all bank exposures convert ed int o asset s
wit h each exposure t hen m ultiplied by t he supervisor risk weight ing, based on level
of risk
o 2 m inim um rat ios ( or lim it s) in which regulat ory capit al is linked t o asset risk
weight ings:
Regulat ory capit al divided by risk- weight ed asset s m ust be equal t o or great er
t han 8%
Tier 1 capit al divided by risk- weighted asset s m ust equal at least 4% .
10
S T R U CT U R E O F B A S EL I I
The new capit al adequacy fram ework - Basel I I - offers great er flexibilit y by est ablishing
a num ber of risk- sensit ive approaches and incent ives for im proved risk m anagem ent .
Banks are asked t o allocat e less capit al for count erpart ies wit h higher rat ings and m ore
capit al for t hose wit h higher risk. The fram ework consist s of t hree pillars as follows:
o
o
o
Pillar 1 ( Minim um Capit al Requirem ent ) deals wit h t he required m inim um capit al t hat
each bank m ust provide t o cover credit , m arket and operat ional exposures.
Pillar 2 ( Supervisory Review Process) est ablishes t he supervisory review process
aim ed at ensuring an adequat e level of bank capit al t o cover t he full scope of bank
risks.
Pillar 3 (Mar ket Discipline) addresses m arket discipline and t he specifics of m inim um
lim it s of public disclosure.
I . Pilla r 1 - M in im u m Capit a l Re qu ire m en t
Pillar 1 est ablishes t he m inim um capit al requirem ent in relat ion t o credit risk, m arket
risk and operat ional risk. I n Basel I I , t he required level of bank capit al is at least 8% of
risk - weight ed asset s. Wit hin t his cont ext , capit al is divided int o several cat egories:
o
o
o
Tier 1 capit al, i.e. t he m ost basic level of capit al consist ing of shares plus noncum ulat ive preferent ial shares and reserves, subt ract ed by goodwill. Tier 1 capit al
m ust com prise at least 50 percent of bank capit al.
Tier 2 capit al, consist ing of asset revaluat ion value, general reserves, hybrid capit al
inst rum ent s and subordinat ed loans. This t ier m ay not exceed 50 percent of capital
Tier 3 capit al, was added in t he 1996 Capit al Accord Am endm ent , but is used only t o
cover t he port ion of t he bank capit al requirem ent allocat ed t o m arket risk. This
cat egory consist s of special t ypes of short- t erm subordinat ed loans.
I .1 . Cre dit Risk
Basel I I allows a financial inst it ut ion t o calculat e credit risk for com pliance wit h capit al
regulat ions by one of t he following t wo m et hods:
o Under t he St andardised Approach ( SA) , t he bank uses a list of risk weightings t o
calculat e t he credit risk for it s asset s. The risk weight ings are linked t o rat ings issued
for t he governm ent , financial inst it ut ions and com panies by an ext ernal rat ing
agency.
o The I nt ernal Rat ing Based Approach ( I RB) allows banks t o use t heir own int ernal
m odels for count erpart ies and exposures. This allows for m ore specific different iat ion
of risk am ong various exposures, producing a level of capit al m ore com m ensurat e t o
risk.
Cre dit Risk—St a n da rdised Approa ch ( SA)
Under t his approach, t he bank allocat es cert ain risk weight ings for each cat egory of
asset s and off-balance sheet it em s t o arrive at a t ot al figure for risk- weight ed asset s as
follows:
Risk- W eigh t e d
w eigh t ing
Asse t s
=
Tot a l
e x posur es
x
r isk
11
Allocat ions for each risk weight ing are based on general debt or cat egories ( governm ent ,
bank or corporat e) , which subsequent ly classified furt her according t o rat ings issued by
an ext ernal credit rat ing agency. The st andardised approach prescribes risk weight ings
based on differences in t he nat ure of t he asset s and ext ernal credit rat ings t o produce a
m ore risk- sensit ive result in com parison t o t he current Accord. The risk weight ings for
t he governm ent , ot her banks and corporat e exposures are different iat ed according t o t he
ext ernal credit rat ings. A 100 percent risk weight ing produces a capit al charge at 8% of
t he exposure value. Sim ilarly, a 20% risk weight ing produces an equivalent capit al
charge of 1.6% ( 20% x 8% ) .
Ot her risk weight ings have also been est ablished according t o differences in t he nat ure
of exposure. Exam ples of risk weight ings for t hese cat egories in use are:
-
35% for exposures t o resident ial housing com plying wit h st rict prudent ial crit eria;
-
75% for ret ail exposures ( loans t o sm all and m edium ent erprises m eet ing cert ain
crit eria enabling t hem t o be t reat ed as ret ail businesses) ;
-
100% for exposures t o com m ercial propert ies, wit h lim it ed exem pt ions under
certain conditions;
-
150% for high risk exposures, such as loans past due; and
-
350% for securit ised com ponent s rat ed BB+ and BB-.
Cre dit Risk—I n t e r na l Ra t in g Ba se d Appr oach ( I RB)
The I RB approach recognises t hat banks are cust om arily bet t er inform ed of t heir debt ors
t han a rat ing agency. This approach enables a bank t o apply m ore precise
different iat ions for each risk in com parison to t he seven risk cat egories ( 0% , 20% , 35% ,
50% , 75% , 100% and 150% ) in t he st andardised approach.
There are t wo approaches used in t he I RB, bot h of which are based on st rict
m easurem ent st andards and m et hodology and require supervisor approval:
-
Fou n da t ion I RB – t he bank calculat es probability of default ( PD) for each debt or
and t he supervisor provides ot her input , such as loss given default ( LGD) and
exposure at default ( EAD) .
-
Advan ce d I RB – in addit ion t o PD, t he bank includes ot her input s such as EAD, LGD
and m at urity ( M) . St rict er requirem ent s apply for using t his approach in com parison
t o foundat ion I RB.
Maj or param et ers in t he I RB approach:
- Probability of Default is t he likelihood t hat a debt or will default on obligat ions. All
banks m ust provide an int ernal m odel of PD for each debt or cat egory.
- Loss Given Default ( LGD) is t he est im at ed percent age of loss t hat would occur in t he
event of a debt or's default .
- Exposure at Default ( EAD) is t he est im at ed exposure t o a part icular debt or in t he
event of default .
- Mat urit y ( M) is t he effect ive t enor ( in years) of a bank exposure.
Asse t Ca t e gor ies in t h e I RB Appr oach
-
Corporat e Exposures – debt liabilit ies owed by com panies or arising from
part nerships or ownership. This cat egory is divided int o five sub- assets: proj ect
financing, purchase financing, com m odit y financing, incom e- generat ing real est at e
and high volat ilit y com m ercial real est at e.
-
Bank Exposures – exposures t o banks and securit ies com panies.
12
-
Governm ent Exposures – exposures t o t he governm ent , t he cent ral bank, public
sect or ent it ies and MDBs.
-
Ret ail Exposures – ret ail loans including loans t o individuals and sm all- scale
businesses, credit card operat ions, working capit al loans, hom e m ort gages and fixed
inst alm ent loans. Basel I I ident ifies t wo sub- cat egories: exposures guarant eed by
resident ial propert y and ret ail exposures m eet ing cert ain qualificat ions, including
ot her ret ail credit .
-
Equit y Exposures – ownership int erest s in com panies, part nerships and ot her
corporate business.
I n ce n t i v e s
The capit al rules are designed t o encourage banks t o shift from t he
st andardised approach t o t he I RB and from Foundat ion I RB t o
Advanced I RB. By swit ching t o a m ore advanced approach, m any
banks will benefit from reduced capit al allocat ion under t he capit al
rules as a result of t he m ore accurat e linkage bet ween capit al and risk.
Nevert heless, t he possibilit y rem ains t hat bank port folios are on
average higher risk and t he I RB approach dem ands a higher st andard
t han t he st andardised approach.
M it igat ion of Cre dit Risk
A lender can m it igat e credit risk if a debt or provides collat eral or a t hird party
underwrit es t he debt or’s obligat ions or t he bank buys credit prot ect ion, for exam ple
t hrough credit derivat ives, or by ot her m eans. Com pared t o t he Accord 88, Basel I I
provides for broader recognit ion of credit risk m it igat ion t echniques. Basel I I allows
banks t o recognise t he following form s of collat eral:
- Cash
- Designat ed securit ies issued by t he governm ent , public sect or ent it ies, banks,
com panies and securit ies com panies
- Designat ed negot iable equit ies
- Designat ed m ut ual funds
- Gold
For banks using t he st andardised approach t o calculat e credit risk, Basel I I offers t wo
possible m et hods for credit risk m it igat ion:
-
The sim ple approach, which enables
g
uarant eed claim s t o be assigned a risk
weight ing against t he collat eral inst rum ent , subj ect t o a m inim um lim it of 20% .
-
The com prehensive approach, focused on t he cash value of collat eral. This approach
uses t he haircut t o calculat e volat ilit y of collat eral value. This m ay be t he st andard
haircut as det erm ined by t he Basel Com m it t ee or an est im at e of collat eral volat ility
prepared by t he bank.
I f a bank is approved for use of an int ernal m odel, t he opt ions of t he sim ple approaches
described above are not available. I n t he case of banks using t he I RB approach, t he LGD
com ponent is also adj ust ed t o reflect t he benefit of using collat eral t o reduce losses.
A s s e t S e cu r i t i s a t i o n
Securit isat ion is a t echnique em ployed by banks t o t ransfer risk while raising liquidit y.
Tradit ionally, bank asset s are pooled and t hen sold by issuing securit ies guarant eed by
t hat pool of asset s. I n Basel I I , banks m ust use t he securit isat ion fram ework in
13
calculat ing t heir capit al requirem ent s against exposures arising
securit isat ion and synt heses or sim ilar st ruct ures wit h t hese feat ures.
from
t radit ional
Because of t he m any different m et hods of securit isat ion, t he det erm inat ion of t he capit al
required t o cover securit isat ion exposures m ust be based on econom ics subst ance over
form . The sam e principle also applies t o supervisors, who m ust give great er em phasis t o
econom ics subst ance in det erm ining whet her t he exposure fit wit hin t he securit isat ion
fram ework for calculat ing bank capit al adequacy.
I n securit isat ion, t he bank m ay act as t he original credit or or invest or for t he securit ised
asset s. I n eit her of t he t wo cat egories, t he bank role can vary widely. What ever t he
form , Basel I I st resses t hat banks m ust allocat e capit al t o cover various form s of
securit isat ion.
I . 2 . M a r k e t R i sk
On 1 January 1998, banks in tGhe - 10 count ries were
required t o allocat e capit al t o cover m arket risk ( as
st ipulat ed in t he m arket risk am endm ent t o t he Basel
Accord) . The bank capit al requirem ent for m arket risk is
det erm ined by t wo m et hods.
The first is t he st a ndar dise d a pproach, which applies a building block approach for
int erest rat e and equit y inst rum ent- relat ed t ransact ions. This approach different iat es
bet ween calculat ion of capit al charges for specific risks and general m arket risk.
The second is t he in t er n a l m odel a pproa ch, which enables banks t o use int ernal
m et hods com plying wit h t he qualit at ive and quant it at ive crit eria det erm ined by t he Basel
Com m it t ee, subj ect t o approval from t he supervisory aut hority. This approach set s
capit al charges at a higher level t han t he previous day's VaR or t he average daily VaR for
60 working days m ult iplied by t hree m inim um fact ors. Banks m ust calculat e t he VaR on
t he basis of daily value wit h
-
one- t ailed confidence int erval of 99%
-
10- day m inim um holding period
-
one- year m inim um observat ion period.
The int ernal m odel used by t he bank m ust accurat ely cover cert ain risks relat ed t o
opt ions and opt ion-like inst rum ent s.
14
I . 3 . O p e r a t i o n a l R i sk
The Basel Com m it t ee defines operat ional risk as t he “ risk t hat originat es direct ly or
indirect ly from inability or failure of int ernal processes, persons and syst em s, as well as
from ext ernal event s." Three approaches m ay be used t o det erm ine t he capit al charges
for operat ional risk:
o
The Ba sic I ndica t or Approa ch calculat es capit al charges for operat ional risks on
t he basis of a cert ain percent age ( alpha fact or) of gross incom e used as an est im at e
for bank risk exposures. Under t his approach, t he capit al t hat m ust be allocat ed by
t he bank t o cover losses arising from operat ional risks equals a cert ain percent age of
average gross incom e over a t hree year period.
o
The St a nda r dise d Approach requires an inst it ut ion t o disaggregat e it s act ivit ies
int o eight st andard business lines. The capit al charge for each business line is
calculat ed by m ult iplying it s gross incom e by a cert ain predet erm ined const ant ( bet a
fact or) t hat is different for each business line.
o
I n t he Adva n ce d M e asu re m en t Appr oach, t he calculat ion of t he capit al
requirem ent is t he sam e as t he risk m easurem ent generat ed by a m odel for
m easuring operat ional risk developedi nt ernally by t he bank. The bank m ust m eet
t he qualit at ive and quant it at ive crit eria st ipulat ed in Basel I I and m ust have approval
from t he supervisory aut horit y.
Ca l cu l a t i o n o f Ca p i t a l A d e q u a cy
Basel I I requires banks t o allocat e capit al at 8% of risk-weight ed asset s, calculat ed
according t o t he following form ula:
For exam ple, a bank has USD10 billion in risk-weight ed asset s, a USD300 m illion capit al
charge for m arket risk and a USD100 m illion capit al charge for operat ional risk. The
m inim um capit al requirem ent for t he bank is:
= [ USD10 billion + 12.5 x ( USD300 m illion + USD100 m illion) ] x 8% = USD1.2 billion
This m eans t hat t he bank m ust allocat e capit al of at least USD1.2 billion.
I I . P i l l a r 2 - T h e S u p e r v i so r y R e v i e w P r o ce s s
Pillar 2 focuses on t he review process wit hin t he supervisory fram ework t hat is aim ed at
ensuring t hat banks m aint ain levels of capit al com m ensurat e t o t heir risk profile. The
supervisory review process seeks t o ensure t hat banks calculat e t heir capit al adequacy
t o cover t he full scope of risk and supervisors assess and t ake any necessary act ions t o
respond t o t he capit al calculat ions m ade by t he bank.
The supervisor m ay ask t he bank t o set aside capit al in excess of t he m inim um capit al
rat io or t ake rem edial m easures such as st rengt hening of risk m anagem ent or ot her
act ions. I f a higher
r at io becom es necessary, t he supervisor m ay int ervene if bank
capit al is below t hat lim it .
15
Pillar 2 requires banks t o conduct regular st ress t est ing t o
est im at e how m uch capit al would be required under crisis
condit ions. The bank and t he supervisor m ust use t he t est result s
t o ensure t hat bank capit al is at an adequat e level.
Pillar 2 encom passes four key principles:
o
Banks m ust have a process for calculat ing overall capit al adequacy based on t heir
risk profile and a st rat egy for m aint aining t heir level of capit al;
o
The supervisor m ust review and evaluat e t he st rat egy and capital adequacy
calculat ions m ade int ernally by t he bank and t he abilit y of t he bank t o m onit or and
ensure com pliance wit h t he prescribed capit al rat io;
o
The supervisor m ay order a financi al inst it ut ion t o operat e above t he prescribed
capit al rat io and has t he aut horit y t o order a bank t o allocat e capit al above t he
m inim um lim it ; and
o
The supervisor m ay int ervene at an early st age t o prevent decline in bank capit al
below t he m inim um lim it and t o ensure t hat t he bank t akes rem edial m easures if t he
level of capit al is not m aint ained or sinks t o it s form er level.
I I I . P i l l a r 3 : M a r k e t D i s cl o su r e
Pillar 3 requires banks t o disclose adequat e inform at ion for m arket
players t o underst and t he risks involved in t he banks. This enables
m arket players t o assess t he key inform at ion on t he scope of risk,
capit al, risk exposures, risk m easurem ent process and bank capit al
adequacy.
I n som e cases, disclosure serves as a special crit eria in Pillar 1 enabling t he bank t o
apply a lower risk weight ing and/ or use a part icular m et hodology. This is expect ed t o
operat e as a form of direct sanct ion because of failure t o com ply wit h t he disclosure
requirem ent s ( e.g., not perm it t ed t o apply lower risk weight ings or use cert ain
m et hodologies) . Pillar 3 also discusses t he issues of t he role of significant inform at ion,
frequency of disclosure and issues regarding propriet ary inform at ion.
16
F r e q u e n t l y A sk e d Q u e st i o n s
1 . W h at is BI S?
The Bank for I nt ernat ional Set t lem ent s ( BI S) is an int ernat ional organisat ion t hat
prom ot es int ernat ional m onet ary and financial cooperat ion and operat es as t he bank for
cent ral banks. To m eet it s responsibilit ies, BI S carries out a num ber of key act ivit ies.
o As a forum for prom ot ing discussions and policy analyses am ong cent ral banks
and wit hin t he int ernat ional financial syst em .
o As a research cent re for econom ics and m onet ary policy
o As a leading part ner for cent ral banks in financial t ransact ions
o As an agent or represent at ive for cent ral bank dealings in int ernat ional financial
act ivit ies.
2 . W h at is t he Base l Com m it t e e on Ba n k in g Su pe r vision ?
The Basel Com m it t ee on Banking Supervision ( BCBS) , bet t er known as t he Basel
Com m it t ee, was est ablished in a volunt ary act ion by t he m onet ary aut horit ies of t he G10 count ries and a num ber of ot her nat ions. The com m it t ee has no official reach as an
int ernat ional supervisory aut horit y and it s decisions are never int ended t o be legally
binding.
The Basel Com m it t ee was set up by cent ral bank governor s from t he G- 10 count ries at
t he end of 1974 and convenes four t im es a year. These count ries are represent ed by
t heir cent ral banks and also t he aut horit ies responsible for supervision of t he banking
business if not under t he powers of t he cent ral bank. The Com m it t ee develops policy
guidelines t hat nat ional supervisory aut horit ies m ay decide on as appropriat e t o t he
supervisory policy t o be im plem ent ed by t he individual count ry.
The Basel Com m it t ee form ulat es supervision st andards and guidelines gof a eneral
nat ure and issues st at em ent s wit h broad applicat ion on best pract ices. This is int ended
t o enable each aut horit y t o t ake m easures for applying t hese st andards wit hin a legal
and regulat ory fram ework appropriat e t o t he individual count ry’s syst em .
The m ost im port ant out put of t he Basel Com m it t ee is t he ruling on m inim um capit al
st andards for banks worldwide. The Basel Capit al Accord was first announced in July
1988 and was im plem ent ed by all m em bers of t he Basel Com m it t ee in 1992. Alt hough
t he accord was init ially t arget ed at int ernat ionally act ive banks, it ult im at ely gained
broad int ernat ional accept ance am ong banks and supervisory aut horit ies. More t han 100
count ries around t he world have now adopt ed t he Basel Accord.
3 . W h at a r e t h e diffe re n ce s be t w e en Ba se l I a n d Ba se l I I ?
Basel I I builds on t he basic st ruct ure of t he 1998 accord ( Basel I ) t o det erm ine capit al
requirem ent s in relat ion t o credit and m arket risk and t o develop a m ore risk- sensit ive
capit al fram ework. This has been achieved by adj ust ing capit al requirem ent s t o credit
risk and also by int roducing changes in t he m et hod for calculat ing capit al t o cover
exposures from risk of losses at t ribut able t o operat ional failures.
Even so, in broad t erm s t he Basel Com m it t ee has ret ained t he aggregat e level of t he
m inim um capit al requirem ent and est ablishes incent ives for applicat ion of t he m ore
advanced risk- sensit ive approaches wit hin t he Basel I I fram ework. Basel I I com bines t he
m inim um capit al requirem ent wit h supervisory review and m arket discipl ine t o prom ot e
im provem ent in risk m anagem ent .
17
4 . W h at a r e t h e obj e ct ives of t h e Ba se l Ca pit al Accor ds?
The obj ect ives of Basel I and Basel I I are essent ially t he sam e. First , t he Basel I
fram ework was designed t o im prove soundness and st abilit y of t he int ernat ional banking
system . Secondly, t he Basel I fram ework was expect ed t o creat e a level playing field
am ong different count ries wit h a high level of consist ency in percept ions t o reduce
sources of unfair com pet it ion am ong int ernat ionally act ive banks. I n t he Basel I I
fram ework, t he Com m it t ee believes t hat t he changes t o t he exist ing approaches will
encourage t he banking indust ry t o use t he im proved risk m anagem ent m et hods.
5 . I s it com pulsor y for a n a t ion t o im ple m e n t Ba se l I I ?
No count ry is required t o im plem ent Basel I I . No policy issued by BI S is legally binding
on any count ry. For t his reason, im plem ent at ion of Basel I I is a decision at t he individual
count ry level, t aking int o account t he st at e of preparedness of t hat count ry's banking
system .
6 . W h a t im pact does Ba se l I I h a ve on a na t ion ?
When a count ry im plem ent s Basel I I , t his act ion is expect ed t o st rengt hen financial
syst em st abilit y by prom ot ing advancem ent in risk m anagem ent and capit al adequacy in
t he banking syst em . Furt herm ore, Basel I I is also expect ed t o:
o I m prove corporat e governance and risk m anagem ent
o Creat e m ore efficient capit al allocat ion and build a robust capit al st ruct ure
o St rengt hen st andards of t ransparency
o I m prove bank supervision in regard t o processes and im plem ent at ion.
7 . Ca n Ba se l I I be im ple m e n t e d in I n don esia?
Yes. Basel I I is a broad policy fram ework consist ing of a set of best pract ices applied
worldwide. The concept s in Basel I I can t herefore be applied in any count ry, including
I ndonesia.
8 . W h y m u st Ba sel I I be im ple m en t ed in I n done sia?
Basel I I prescribes a m ore risk- sensit ive fram ework for calculat ion of t he capit al
requirem ent . These capit al adequacy calculat ions also t ake int o account t he various risks
involved on a m ore com prehensive scale. This will encourage banks t o im prove t heir
risk m anagem ent in order t o obt ain a m ore precise value of econom ic capit al. I t will also
encourage supervisors and m arket players t o play a great er role in financial syst em
st ability.
9 . I s it a ppr opr iat e for I n don esia t o im ple m e n t Ba se l in t h e n e a r fu t u r e ?
Yes. Since t he int roduct ion of Basel I , t he I ndonesian banking syst em has undergone far
reaching changes from :
o Globalisat ion
o Developm ent s in t echnology
o I nnovat ions in t he financial world
Furt herm ore, Basel I focuses only on credit risk and m arket risk, t hereby sim plifying
assum pt ions of risks in a way t hat will not prot ect bank soundness.
Basel I I provides a fram ework capable of m aint aining t he soundness and st abilit y of t he
banking syst em t hrough:
o St rengt hening of int ernal processes
o Prom ot ing t he use of m ore advanced and sophist icat ed risk m anagem ent
pract ices
o Risk m easurem ent s m ore accurat ely depict ing t he t rue level of risks carried by
t he bank
o I m provem ent s in t ransparency.
18
1 0 . W h a t a pproa ch w ill be use d in I n don e sia ?
Bank I ndonesia will int roduce t he st andardised, int ernal rat ing- based and advanced
approaches. These approaches will be phased in over t im e. The decision on t he approach
t o be used will be m ade by individual banks wit h approval from t he supervisor.
1 1 . M ay ban ks choose t h e a ppr oach t h ey use ?
Yes, banks m ay choose t he approach t hey wish t o use. However, t he use of any
approach ot her t han t he st andardised approach m ust be approved by t he bank
supervisor. I f a bank has already used t he int ernal rat ing based or advanced approach, it
will not be perm it t ed t o replace t he approach in use wit h t he st andardised approach
wit hout approval from t he bank supervisor.
1 2 . W ill ba nk s be r e qu ire d t o u se t h e I n t e r na l Ra t in g- Ba se d or Adva n ce d
a pproach?
No, banks are not required t o use eit her t he int ernal rat ing- based or t he advanced
approach. The decision about which approach t o use is ent irely at t he discret ion of t he
individual bank. I f a bank is unable t o im plem ent an int ernal rat ing- based or advanced
approach, it will be encouraged t o rem ain wit h t he st andardised approach.
19
GL O S S A R Y
-
Pillar 1: Rules est ablishing a m inim um rat io of capit al t o risk- weighted asset s.
-
Pillar 2: The supervisory review pillar, requiring supervisors t o perform a qualit at ive
review of t he capit al allocat ion t echniques used by t he bank and com pliance wit h
relevant st andards.
-
Pillar 3: Disclosure requirem ent s t hat facilit at e m arket discipline.
-
I nt ernal Rat ing: Result of a bank’s risk m easurem ent of it s credit port folio.
-
Ext ernal Credit Rat ing: Rat ing issued by an external rat ing agency.
-
Consolidat ion: Measurem ent of bank risk encom passing t he ent ire business group
linked to t he bank.
-
Operat ional Risk : Risk arising direct ly or indirect ly from t he inabilit y or failure of
int ernal processes, persons or syst em or from ext ernal event s.
-
Credit Risk: Risk of loss arising from default by a debt or or count erpart y.
-
Market Risk: Risk of loss arising from a t rading posit ion when prices undergo change.
-
Mit igat ion of Credit Risk : A set of t echniques enabling a bank t o prot ect part of it s