1. TK 6413 / TK 5413 : ISLAMIC RISK MANAGEMENT TOPIC 8: CHARACTERISTICS, STRENGTHS AND WEAKNESSES OF THE BASEL II FRAMEWORK 1

2. (I) THE THREE PILLARS OF BASEL II a)Pillar I: Minimum Capital Requirements Pillar I defines what capital is and sets out the minimum regulatory capital requirements, letting banks develop their strategies so as to deal with credit, market and operational risk. It should be stressed while calculating the capital ratio under Pillar 1 that it must be no lower than 8% as shown below While the minimum capital ratio of 8% has remained unchanged (from Basel 1 to Basel II), the operational risk has now been added to the existing two types of risk; credit and market risk. 2 8% Capital (total risk) – (weighted assets for credit risk) + capital charges for market risk and operational risk) x 12.5

3. 3 b)Pillar II: Supervisory Review Process Pillar II defines the structure of reporting to regulators that has to be adopted by banks. The supervisory review process of the framework is intended not only to ensure that credit institutions have adequate capital to support all the risks in their business, but also to encourage them to develop and use better risk management techniques in monitoring and managing their risks. Under the pillar, the supervisors will review the risk management frameworks of the credit institution. c)Pillar III: Enhanced Disclosure The third pillar sets out the requirement for disclosure to markets, leading to greater transparency and accountability from bank managements.

4. 4 d)Objectives of Basel II: To encourage best-practice, sophisticated, analytically-driven, risk management policies based on each credit institutions experience; To establish a more comprehensive approach for addressing the different types of risk; To promote safety and soundness in the financial system; the new framework should at least maintain the current overall level of capital in the system; To increase the effectiveness of operational risk quantification; To increase informative integration across the whole business to manage, market, credit and operational risks;

5. 5 To increase the need to focus on loss data collection and ensure information data reliability and timeliness of measurements; To define more effective ways to track, calculate, monitor, analyze and report risk measures; To ensure appropriate documentation of risk management systems; To effectively integrate different risk types; and To promote a national supervisory and regulatory process to ensure the maintenance of adequate capital.

6. (II) THE FRAMEWORK FOR MARKET RISK a)The framework for market risk in Basel II The regulatory framework proposed by the Basel Committee relies heavily on the realization of failures to predict the reality. The number of failures realized over a year is assigned to a multiplication factor, given the condition that these failures are not more than 10 over the year. Consequently, the multiplication factor is multiplied by the 60-days average value- at-risk (VaR), value in order to produce the relevant capital requirements. Thus, the level of capital requirements relies on both: i.The multiplication factor; and ii.The inter-temporal level of VaR measures. 6

7. (III) THE FRAMEWORK FOR CREDIT RISK a)The framework for credit risk in Basel II The Basel Committee proposes two approaches for measuring the capital requirements for credit risk: The Standardized Approach (SA); and The Internal Ratings-based Approach (IRB). i.Standardized Approach In the SA, the bank allocates a risk weight to different types of claim. The risk weights are 0%, 20%, 50%, 100% and 150% and the main risk groups are banks, non-banks, and sovereigns. Then the bank allocates a sum of risk weighted assets values. For example, a risk weight of 50% indicates that the exposure will be included in the calculation of assets at half the value. The capital change is therefore 8% of the asset value. In the SA, the risk weighting for the individual risk groups will substantially depend on assessments by external credit-assessment institutions. 7

8. 8 ii.Internal Rating-based Approach (IRB) Under the IRB approach, banks use their own methods of management and credit risk measurement in order to calculate the regulatory capital. The internal rating methods are subject to supervisory recognition, so the banks have to fulfill a number of minimum requirements if they want to qualify for the IRB approach. Banks that receive supervisory approval to use the IRB approach may rely on their own internal estimates of risk components in determining the capital requirement for a given exposure. The risk components include, PD-probability of default LGD-loss given default EAD-exposure at default The expected losses (EL) = (PD x LGD x EAD)

9. 9 iii.Categorization of exposures and key elements Under the IRB approach, banks must categorize their banking book exposures into five broad class of assets with different risk characteristics: Banks; Sovereigns; Corporate; Retails; and Equity Under Basel II for each of the five assets classes there are three key elements: Risk components – estimates of the risk parameters; Risk weighted function; Minimum requirements.

10. 10 iv.Alternative IRB methodologies Basel II provides two alternatives IRB methodologies: Foundation IRB: Under this approach, banks must make their own estimates on the PD, while the remaining components are specified by the supervisory authorities. Advanced IRB: Under this approach, banks are allowed to use their internal estimations, not only for the PD, but also for the LGD and EAD.

11. 11 v.Capital Requirements For calculating the capital requirements K, we adopt the following relationships:

12. 12 vi.Criticism on Basel II for credit risk A serious criticism is that the operation of Basel II will lead to a more important business cycle. This criticism appears because credit models used for Pillar I compliance typical use a one-year time horizon. This would mean that, during a downturn in the business cycle, banks would need to reduce lending as their model forecast increased losses, increasing the magnitude of the downturn. Regulators should be aware of this risk and can be expected to include it in their assessment of the bank models used. More complicated risk measures unjustly advantage the larger banks; developing countries generally also do not have these banks and that Basel II will disadvantage the economically marginalized by limiting their access to credit or by making it more expensive.

13. (IV) THE FRAMEWORK FOR OPERATIONAL BANK a)Characteristic of operational risk from a Basel II viewpoint The current definition of operational risk proposed by Basel II is “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events” and is clearly based upon the causes of operational risk. Operational risk is not equivalent to operational loss experience. If the losses suffered by retail banks were steady from one year to another, the banks would simply feature these expected “operational losses” into their business plans factor and pricing schemes. Instead, operational risk is the risk of huge and unexpected inconsistency in operational losses over time. In the past operational risk was controlled based on qualitative risk management practices; today the risk have become more complex, therefore, financial institutions need to improve their methods of handling these form of risk. However, in contrast to market and credit risk, financial institutions may try to limit market disclosure giving any evidence of operational risks and the corresponding losses because more operational risks and caused by internal factors. 13

14. 14 Given the advances made in IT, deregulation and severe international competition are opening doors to more operational risks. On the other hand, the sophistication of operational processes aided by information technology, increase the applicability of business intelligence in financial institutions that can effectively be used in the framework of operational risk management.

15. 15 According to Jameson (2002), operational risk management will stay at the top of the agenda in risk management because of: Regulatory concern and the operational risk capital charge in the new Basel II Accord; Increased use of economic-capital models that require the factoring in of operational risk; Automation, outsourcing, large-volume service provision and fee-based businesses, meaning that financial institutions are increasingly expected to operational risk; The ease for financial institutions to substitute measured risk for unmeasured operational risk; and Shareholders penalizing banks that have not identified and communicated their operational risk profile.

16. 16 b)Strengths of Basel II in the operational risk framework One of the foremost benefits of the Basel II Accord in terms of operational risk management is the fact that it has acknowledged that operational risk is an area that needs attention in the financial industry. It has thus enforced that regulatory capital be reserved for it. It has now given a definition for operational risk. Previously in Basel I, operational risk is implicitly assumed to be captured in the calculation of credit and market risk. The flexibility of the Basel II Accord which allows regulators and banks to choose different approaches to calculate capital requirements is an advantage to the management of operational risk which is in its infancy and standard methodologies are not well known. The Basel II Accord permits regulators to allow “sophisticated” banks to use their own internal ratings to establish risk levels rather than those assigned by private credit-rating agencies.

17. 17 The choice of basic and standardized approaches also helps smaller institutions grasp the concept of operational risk management. The fact that they can move from one approach to another and even use different approaches for different business lines will encourage them to develop more sophisticated approaches in the future as business lines need to be given incentives that motivate them to reduce operational risk. Additionally since the introduction of Basel II, operational risk management has become a driver for shareholder value because banks review it as a tool to reduce volatility in earnings.

18. 18 c)Weaknesses of Basel II in the operational risk framework Overall the concerns are over the complexity of the requirements; the continuing lack of transparency around operational risk practices; there are also other concerns about how difficult the requirements will be to implement and how challenging it will be for supervisions to monitor compliance. Some of the most prominent concerns are highlighted in the following subsections: Operational risk transfer Assessment of operational risks Data availability

19. 19 d)Operational risk modeling The accuracy of operational risk measurement methods strongly depends on the accuracy of operational risk models and the availability of data. Proper operational risk modeling requires a good understanding of repetitive patterns that cause the operational risk under consideration. The appropriateness of those risk models is fundamentally linked to data availability. Many banks do not yet have an internal database of historical operational loss events. Those databases that exist are occupied mostly by high-frequency, low-severity events, and by a few large losses. As a result, relatively little modeling of operational risk has occurred, and banks have been prone to allocate operational risk capital via a top-down approach.

20. 20 e)Expected losses and unexpected losses The Basel II Accord sets capital requirements to cover both EL and UL without differentiating between the two. However, the definition of capital is not changed to reflect the capital that supports EL and the pricing margins that act as additional protection against losses. In the context of operational risk, EL are routinely built into pricing. f)Beta values Another challenge post by the Basel II Accord is whether the different beta values across business lines can really be distinguished and whether the distribution in beta estimates reflects differences across banks in the quality and calibration of their internal economic measures.