Slide MGT305 Slide11
Basel I, Basel II, and
Solvency II
Chapter XII
The Reasons for Regulating
Banks
• The purpose is to ensure banks keep
enough capital for the risks they take.
• Governments would like to make the
probability of a bank failing small.
• Governments would like to create and
maintain a stable economic system.
Bank Regulation Pre-1988
• Prior to 1988, bank regulators tended to
regulate bank capital by setting minimum
levels for the ratio of capital to total assets.
• The lack of consistency in several countries
lead to a problem in which total assets
were no longer a good indicator of the total
risks taken.
The 1988 BIS Accord
• Supervisory authorities from several
countries formed the Basel Committee on
Banking Supervision.
• This is also known as The Accord or Basel
I recently.
The Cooke Ratio
• It considers both on-balance-sheet and off-
balance-sheet items to calculate the bank’s
total risk-weighted assets (amount).
• It is a measure of the bank’s total credit
exposure.
• Each item on the on-balance-sheet item is
assigned risk weight reflecting its credit risk.
The Cooke Ratio
The Cooke Ratio
Risk weight
(%)
Asset category
0
Cash, gold bullion, claims on OECD governments such as
Treasury bonds or insured residential mortgages
20
Claims on OECD banks and OECD public sector entities
such as securities issued by US government agencies or
claims on municipalities
50
Uninsured residential mortgage loans
100
All other claims such as corporate bonds and lessdeveloped country debt, claims on non-OECD banks
Real estate, premises, plant, and equipment
Example
• The assets of a bank consist of $100
million of corporate loans, $10 million of
OECD government bonds, and $50 million
of residential mortgages. The total of riskweighted assets is
1.0*100 + 0.0*10 + 0.5*50 = $125million
The Cooke Ratio
• Off-balance-sheet items are expressed as a credit
equivalent amount.
• Credit equivalent amount is the loan principal
that is considered to have the same credit risk.
• For non-derivatives the credit equivalent amount
is calculated by applying a conversion factor to
the principal amount of the instrument.
The Cooke Ratio
• For an over-the-counter derivative, such as an interest
rate swap or a forward contract, the credit equivalent
amount is calculated as
max(V,0) + aL
• where V is the current value of the derivative to the bank,
a is an add-on factor, and L is the principal amount.
• The bank’s exposure is max(V,0) and the add-on amount,
aL, is an allowance for the possibility of future exposure
increasing.
The Cooke Ratio
• The equation above is the current exposure.
• If the counterpart defaults today and V is
positive, the contract is an asset to the bank and
the bank is liable to lose V.
• However, if the counterpart defaults today and V
is negative, the contract is an asset to the
counterparty and there will be neither a gain nor
a loss to the bank.
The Cooke Ratio
Remaining
maturity
(years)
Precious
Other
metals commod
Exchange rate and gold Equity except gold ities
Interest
rate
1.5
7.5
10.0
8.0
15.0
Example
• A bank has entered into $100 million
interest rate swap with a remaining life of
four years. The current value of the swap
is $2 million. In this case the add-on
amount is 0.5% of the principal, so that the
credit equivalent amount is $2 million plus
$0.5 million, or $2.5 million.
Solvency II
Chapter XII
The Reasons for Regulating
Banks
• The purpose is to ensure banks keep
enough capital for the risks they take.
• Governments would like to make the
probability of a bank failing small.
• Governments would like to create and
maintain a stable economic system.
Bank Regulation Pre-1988
• Prior to 1988, bank regulators tended to
regulate bank capital by setting minimum
levels for the ratio of capital to total assets.
• The lack of consistency in several countries
lead to a problem in which total assets
were no longer a good indicator of the total
risks taken.
The 1988 BIS Accord
• Supervisory authorities from several
countries formed the Basel Committee on
Banking Supervision.
• This is also known as The Accord or Basel
I recently.
The Cooke Ratio
• It considers both on-balance-sheet and off-
balance-sheet items to calculate the bank’s
total risk-weighted assets (amount).
• It is a measure of the bank’s total credit
exposure.
• Each item on the on-balance-sheet item is
assigned risk weight reflecting its credit risk.
The Cooke Ratio
The Cooke Ratio
Risk weight
(%)
Asset category
0
Cash, gold bullion, claims on OECD governments such as
Treasury bonds or insured residential mortgages
20
Claims on OECD banks and OECD public sector entities
such as securities issued by US government agencies or
claims on municipalities
50
Uninsured residential mortgage loans
100
All other claims such as corporate bonds and lessdeveloped country debt, claims on non-OECD banks
Real estate, premises, plant, and equipment
Example
• The assets of a bank consist of $100
million of corporate loans, $10 million of
OECD government bonds, and $50 million
of residential mortgages. The total of riskweighted assets is
1.0*100 + 0.0*10 + 0.5*50 = $125million
The Cooke Ratio
• Off-balance-sheet items are expressed as a credit
equivalent amount.
• Credit equivalent amount is the loan principal
that is considered to have the same credit risk.
• For non-derivatives the credit equivalent amount
is calculated by applying a conversion factor to
the principal amount of the instrument.
The Cooke Ratio
• For an over-the-counter derivative, such as an interest
rate swap or a forward contract, the credit equivalent
amount is calculated as
max(V,0) + aL
• where V is the current value of the derivative to the bank,
a is an add-on factor, and L is the principal amount.
• The bank’s exposure is max(V,0) and the add-on amount,
aL, is an allowance for the possibility of future exposure
increasing.
The Cooke Ratio
• The equation above is the current exposure.
• If the counterpart defaults today and V is
positive, the contract is an asset to the bank and
the bank is liable to lose V.
• However, if the counterpart defaults today and V
is negative, the contract is an asset to the
counterparty and there will be neither a gain nor
a loss to the bank.
The Cooke Ratio
Remaining
maturity
(years)
Precious
Other
metals commod
Exchange rate and gold Equity except gold ities
Interest
rate
1.5
7.5
10.0
8.0
15.0
Example
• A bank has entered into $100 million
interest rate swap with a remaining life of
four years. The current value of the swap
is $2 million. In this case the add-on
amount is 0.5% of the principal, so that the
credit equivalent amount is $2 million plus
$0.5 million, or $2.5 million.