INTERNATIONAL REGULATION OF BANKING SYSTEM

BASEL ACCORD I

Background:

The Basel Committee on Banking Supervision (BCBS) comprises

representatives of the G-10 countries (U.S., U.K., Canada, Belgium,
France, Germany, Italy, Japan, Netherlands, Sweden and Switzerland).

The Basel Accord concluded on July 15, 1988, represents a landmark

financial agreement for the regulation of internationally active
commercial banks. It instituted for the first time minimum levels of
capital held by international banks against financial risks.

Although strictly speaking it only applies to internationally active banks

within the G-10, these minimum capital requirements have become
regulatory standards in more than 100 countries as well.

The basic thrust of the Accord is on adequate capitalisation of banks,

especially those engaged in international business. Adequate
capitalisation was interpreted to mean a minimal level of the ratio of
capital to assets.

In the course of their business, banks create assets (mainly loans and
investments). If these assets are not realised, the banks are unable to
meet their liabilities (mainly deposits and bonds) and have to be bailed
out by the central bank or the government or go bankrupt. Banks’ profits
are related to the level of their assets, and we have seen that banks are
chronically tempted to undertake risky business. If a bank has sufficient
capital at its disposal, then in the event of difficulties, it can draw on this
capital to honour its liabilities.
 However locking up funds as capital, means lower funds available for
granting credit and hence lower profits.

Most banks do maintain some amount of capital even in the absence of

any regulatory requirement but usually this is much lower than
warranted by the risk profile of their business.

Four features of the Accord are noteworthy.

1. It was primarily addressed to internationally active banks.

2. It sought to establish a minimum capital ratio, leaving national
authorities discretion to prescribe higher ratios.
3. It is intended to apply to banks on a consolidated basis (i.e. including
subsidiaries, branches etc.)
4. It stressed repeatedly that capital adequacy was only one of several
dimensions of the financial strength of a bank.

Definition of Capital :

The 1988 capital adequacy rules require any internationally active bank to carry
capital of at least 8% of its total risk-weighted assets. This applies to
commercial banks on a consolidated basis. In the Basel Accord, “capital” has
boarder interpretations. The key purpose of capital is its ability to absorb
losses, providing some protection to creditors and depositors. The Basel accord
recognizes three forms of capital.

1. Core Capital (Tier I) :

This is defined to include

a. equity capital (issued and fully paid ordinary shares, and non-
cumulative preference shares—cumulative preference shares,
where (fixed ) dividends falling due in loss-making years are
cumulated to the dividend liability in following years, are
excluded from Tier 1 capital)

b. Disclosed reserves corresponds to after tax retained earnings

2. Supplementary Capital (Tier II) :

This includes the following categories:

a. Hidden reserves— It is common in some countries for banks

not to disclose their reserves fully in the published balance
sheet (to avoid pressures for higher dividend distribution and
also to avoid giving its clients adverse impressions about the
riskiness of its business). These reserves are of course known to
the supervisory authorities.

b. Revaluation Reserves---Which arise from long-term holdings of

equity securities that are valued at historical acquisition costs.
Such capital could be used to absorb losses on going concern
basis, subject to some discount to reflect market volatility.

c. General provisioning – As a safety cushion, banks usually set

aside a certain proportion of their assets in the form of
provisioning. Two types of provisioning are distinguished –
general provisioning (to cover unforeseen losses) and specific
provisioning (against specific assets which are losing value e.g.
depreciation on premises and fixed machinery, securities of
companies that have failed, non-performing loans defined in
India as loans on which interest is overdue for more than 6
months). General provisioning is counted towards Tier 2
capital, but specific provisioning is excluded. Because in some
countries the two categories are not explicitly distinguished (in
India they are distinguished) . Restrictions have been suggested
by the BCBS on the quantum of Tier 2 capital in this form.

d. Subordinated debt of maturity greater than 5 years is included

in Tier 2 capital, but with limitations on the quantum.
(Subordinated debt is a second- charge item on the bank i.e. in
the event of bank liquidation it will have to be paid after the
 other liabilities have been paid off. However it can be thus used
only in the event of liquidation)
e. Hybrid debt equity instruments – which combine some
characteristics of equity and of debt such as cumulative
preference shares.

3. Tier III capital, for market risk only

Tier 3 capital consists of short-term subordinated debt with a maturity

of at least two years. This is eligible to cover market risk only.

On-Balance Sheet Risk Charges

On-balance sheet assets consist primarily of loans for most credit institutions.
Ideally capital charges should recognize differences in asset credit quality. Basel
accord applies to the notional of each asset a risk capital weight taken from
four categories. Each dollar of risk-weighted notional exposure must be
covered by 8% capital.

Concept of Risk- Weighted Assets (RWA)

The Accord achieves a major break-through in suggesting a measure of assets,

weighted by corresponding risks—the so-called RWA measure. Four weight
categories have been suggested.

1. Category I (weight 0%) :

(i) cash
(ii) gold bullion (at national discretion)
(iii) Claims on central government and central bank (domestic
or foreign), denominated in national currency
(iv) Claims on OECD central governments and OECD central
banks
(v) Claims guaranteed by OECD central governments.

2. Category II (weight 20 %) :
(i) Claims on multilateral development banks or claims
guaranteed by them or claims collateralised by securities
issued by such banks (multilateral development banks
include the World Bank, Asian Dev. Bank, African Dev. Bank,
European Inv. Bank etc.)
 (ii) Claims on banks incorporated in the OECD and loans
guaranteed by such banks.
(iii) Claims on banks outside OECD and loans guaranteed by such
banks, provided the claims and loans have a residual
maturity of less than 1 year.
(iv) Claims on non-domestic OECD public sector entities (PSEs
are defined to include state governments, local authorities
such as municipalities but not public sector enterprise
engaged in commercial operations)
(v) Cash receivables

3. Category III (weight 50%) :

(i) Loans fully secured by mortgage on residential property

4. Category IV (weight 100%)

(i) Claims on the private sector and public sector commercial

companies
(ii) Claims on non-OECD banks of residual maturity exceeding 1
year
(iii) Claims on non-OECD central governments, which are not
denominated in national currency
(iv) Office premises, plant and equipment, and other fixed
machinery
(v) Real estate and other investments (excluding residential
premises)
(vi) Capital instruments issued by other banks
(vii) All other assets

Note:

(i) The Accord is almost exclusively focussed on credit risks. Other risk
categories were considered only in Accord II, to be discussed later.

(ii) The RWA measure above pertains to what are called on balance sheet
items. A characteristic feature of modern banking is the proliferation
of off balance sheet items in recent years.

The credit risk charge (CRC) is then defined for balance sheet items (BS) as

CRC(BS) = 8% * RWA = 8% * ( )
Where RWA represents risk weighted assets and RW is the risk weight
attached.

For example a bank subject to the Basel I Accord makes a loan of $100m to a
firm with a risk weight of 50%. Then the on-balance sheet credit risk charge will
be $100*50%*8% = $4million

Off- Balance Sheet (OFBS) risk charges:

OFBS (off balance sheet items) arise whenever banks engage in contingent
transactions, i.e. transactions which become liabilities for the bank only in the
event of certain exogenous events taking place.

Several examples arise.

1. A resident Indian may want to borrow from an American bank; an Indian

bank can stand as a guarantor for the loan. The Indian bank will have to
repay the loan, in case the resident Indian defaults. This is an OFBS for
the Indian bank. The bank charges a commission to the resident for
providing the guarantee.

2. An Indian company may want to float a bond with a guaranteed high rate
of return (performance bond). It approaches the bank to make up any
shortfall in the interest payments, which may result if the company fails
to record adequate profits in a particular year. This is an OFBS
transaction for the bank, for which it charges a fee.

3. Banks can also act as underwriters for certain security issues (i.e.
promising to buy up a certain portion of any un-subscribed primary
issue). This is also a contingent liability.

4. Banks also engage in derivative trading, which are also considered as

OFBS activities.

OFBS activities usually are quite attractive for banks, yielding high incomes.
However, earlier they were not reported in the banks’ balance sheets, unless
they were actualised. But OFBS activities do represent a risk to banks, and the
Accord explicitly seeks to make such activities transparent.
The Accord also seeks to incorporate the OFBS activities within the risk
accounting framework.

This it does via a system of conversion factors. Each OFBS transaction is

assigned a conversion factor, and after multiplication by the conversion factor,
the OFBS transaction is treated as if it were an on-balance sheet item and
multiplied by the weight corresponding to that category, depending on the
status of the counter-party.

Criticisms of Basel I

Several criticisms were made of the Accord after it was published, and some
of these criticisms were met in the later amendments and revisions to the
Accord.

1. The Accord was criticised for assigning differential risk weights to OECD
and non-OECD exposures of banks.

2. The Accord was criticised for its exclusive focus on credit risk, to the
exclusion of other forms of risk.

3. The Accord does not differentiate between sound and weak banks,
using a “one hat fit all” approach.

4. Finally there are strong theoretical objections to CRAR (capital risk

adjusted ratios) as a method of regulation.
BASEL ACCORD II

As noted earlier, Basel Accord I suffered from several drawbacks. In order to

remedy the more prominent of these, the Basel Committee published a New
Accord. Accord II was far more ambitious in scope than Accord I. It was
finalized in 2004.

Broadly speaking there are 3 pillars to Accord II.

1. Minimum capital requirement
2. Supervisory review
3. Market discipline

FIRST PILLAR

The 2 main departures that Accord II makes from Accord I in the matter of
minimum capital requirements are:

1. Instead of trying to fit all banks into a single framework, it allows banks
a certain latitude in determining their own capital requirements, based
on internal models (subject however to the other 2 pillars)
2. Instead of focussing exclusively on credit risks (as Accord I) it
additionally considers 2 other important risk categories viz. market risk
and operational risk.

The actual calculation of the capital ratio proceeds as follows.

(a) For credit risks, two alternative approaches are proposed.

i. The first is a standardised approach, which is very similar to

the earlier Accord, (in which RWA- risk-weighted assets- is
determined), except that the risk weights are no longer
determined in a set once –for- all fashion, but are revised
depending upon the ratings of the counter-parties by
external credit rating agencies (ECRA). There is also greater
differentiation across risk categories.

ii. The second approach called the internal ratings based

approach (IRB), proposes that banks calculate their own risk
exposures through internal models, and these exposures are
 converted into a single numerical component of RWA in a
prescribed manner.

(b) For market risk also, a similar twin- track approach is followed.
But there are 2 special departures from the treatment of credit
risk. Firstly, the capital charges are determined directly and
then multiplied by 12.5 (reciprocal of 8%) to make them
comparable to the RWA. Secondly, a special type of capital (Tier
3) is introduced for meeting market risk only.

(c) For meeting operational risk, Accord II has specified 3

alternative methods— basic indicator approach, standardised
approach, and internal measurement approach. For operational
risk also capital charges are computed directly and then
multiplied by 12.5 to make them comparable to RWA.

Thus total risk weighted asset is defined as

D = RWA 12.5 Sum of capital charges due to market and operational risk

And the available capital is given by

N = Tier I Tier II Tier III

Subject to the Proviso that

Tier I Tier II 0.08 RWA 12.5 (Capital charges on account of operational
risk)

Tier III capital:

To meet market risk only, a special type of capital viz. tier III capital has been
introduced in the New Accord. It will consist of short-term subordinated debt,
but with a minimum original maturity of 2 years. Tier III capital cannot exceed
250% of the Tier I capital used to meet market risk.
 A. Credit Risks: Standardised Approach

In the standardised approach, risk weights are determined by the supervisor

but based on the credit ratings of approved rating agencies –ECAIs-(criteria for
approval of ECAIs have been set out in Accord II). Weights and ratings for major
counter-parties are set out below.

Counter- Party : Sovereigns

Credit assessment Risk weights

AAA to AA- 0%
A to A- 20%
BBB to BBB- 50%
BB to B- 100%
< B- 150%
Unrated 100%

Counter- Party: Other Banks

Credit assessment Risk weights

AAA to AA- 20%
A to A- 50%
BBB to BBB- 50%
BB to B- 100%
< B- 150%
Unrated 50%

Counter- Party : Corporates

Credit assessment Risk weights

AAA to AA- 20%
A to A- 50%
BBB to BBB- 100%
BB to BB- 100%
< BB- 150%
Unrated 100%
Further features of the risk-weights are the following:
1. Claims on BIS, IMF, European Central Bank :– 0 % weight
2. Claims on non-central public sector entities in a country :- same weights
as for banks in that country
3. Claims on residential property :- 50%
4. Claims on non-residential commercial property :- 100%
5. Off- balance sheet items will continue to be treated as in Accord I
6. If a bank is rated differently by two ECAIs the higher risk-weight will
apply.

Credit Risk Mitigation:

The new Accord gives due recognition to the fact that collaterals will reduce
the risk of an exposure, and hence collateralised loans should carry lower
risk weights than un-collateralised loans.

The following are considered eligible collaterals:

(i) cash on deposit with the same bank

(ii) Securities issued by sovereigns and public sector entities carrying a

minimum rating of BB-

(iii) Bank and corporate securities rated minimum at BBB-

(iv) Equities included in a main stock index (such as Dow Jones, Nikkei,
Sensex etc)

(v) Gold

However, the value of the collateral C is adjusted to CA by applying a so-

called “haircut” H.
CA = C / (1 H)

The value of H will depend on the type of collateral . It varies from 0%

(cash), 4% (sovereign securities), 15% (gold) to 30% (eligible corporate
securities)

The modified risk weight r* is now related to the original risk weight r by the
following formulae:
 1. If the exposure of the loan E is fully covered by the adjusted collateral
value CA, then r* = r w
The weight factor w is 0.15, so that even a fully collateralised asset still
carries a risk weight of at least 15% of the original risk weight.
2. If the loan value is not fully collateralised i.e. E CA, then, r* is equated
to
E – (1-w)CA r E

Credit Risk : IRB Approach

The IRB approach recognises both that individual banks face distinctive risk
profiles and that their own managements know more about these risks than
the supervisory authority. IRB approach therefore gives banks the discretion to
compute their own risk estimates, subject of course to overall supervisory
checks.
However to qualify for this treatment, the supervisory authority has to be
satisfied that the bank meets the following requirements:
1. The bank’s risk management system is conceptually sound and is
implemented with integrity.
2. The bank’s models have a proven track record of reasonable
performance
3. The bank should have an independent risk control unit, (independent
of the trading unit) which reports directly to the senior management
and Board of Directors.
4. The output of the risk management unit should be an integral
component of the planning process and day-to-day operations of the
bank.

The IRB approach for credit purposes, distinguishes 6 different

categories of exposures.
1. sovereigns and public sector entities
2. other banks
3. corporates
4. retail loans
5. project finance
6. equity investment

For each exposure category, there are some differences in detail about the IRB
methodology employed. However, the broad features are similar. In each such
category, two key concepts are identified : (i) risk components and (ii) a risk
weight function.
Risk Components:

Most banks usually have some kind of internal ratings for each borrower.
Based on these, a bank is now required to estimate the PD( probability of
default) for each broad exposure class. This will of course be some kind of a
pooled estimate across different borrowers in the same exposure class.
Another crucial concept is LGD (loss given default) which measures the extent
of loss on a given exposure in the event of default. LGD will be a fraction of the
total exposure, whose exact value will depend upon the extent of
collateralisation, realizability of collateral etc. LGD is usually expressed as a
percentage of the exposure.

Finally the loss to the bank depends on the value of the exposure at default
(EAD).

The bank’s internal model is expected to produce reliable estimates of PD, LGD,
and EAD. These estimates must be based on at least 1 year’s data, sampled
over a minimum of 4 quarters. Below we illustrate the procedure, using the
special case of corporate exposures.

Risk weight Function:

The next step is to translate the risk components derived above into risk
weights, using a so-called Risk weight Function.

For corporate exposures, the risk weight function gives the following risk
weight for given PD, LGD and EAD

RWc = Min. (LGD/50) Bc ; 12.5 LGD

Here LGD is expressed as a whole number (i.e. a 75% loss given default is
simply written as 75)

Where Bc is a benchmark risk-weight for corporates, prescribed by the

supervisor based on statistical calibration and related to PD via the following
table

PD Bc
0.03% 14
0.05% 19
0.1% 29
0.2% 45
0.4% 70
0.5% 81
0.7% 100
1% 125
2% 192
3% 246
5% 331
10% 482
15% 588

Each calculated risk-weight RWc is multiplied by the corresponding EAD, and

aggregating over all exposure categories now yields an estimate of RWA for
credit risks.

Market Risk : Standardised Approach

Just as for credit risk, two approaches have been suggested for dealing with
market risk – a standardised approach and an approach based on internal
models.
Under the standardised approach, 5 distinct sources of market risk are
identified viz.
1. Interest rate risk
2. Equity position risk
3. Foreign exchange risk
4. Commodities risk
5. Risk from options

A detailed treatment of each source of market risk is then undertaken in the

Accord. By way of illustration, we focus on the interest rate risk and the foreign
exchange risk.

Interest Rate Risk:

In the calculation of interest rate risk, one needs to differentiate between

specific and general risk, and separate capital charges apply to the two types of
risk.
Specific risk arises from adverse movements in the price of an individual
security owing to factors related to the individual issuer. Note that both long
positions (one in which the bank holds a security) and short positions (where
the bank has borrowed a security) carry specific risks. If the rate of interest
rises (falls) long (short) positions are adversely affected. Because long and short
positions are affected in opposite ways, netting of positions is allowed for
identical issues in the calculation of specific risk.
For purposes of calculating specific charges, 3 types of securities are
distinguished:
a) government : including (domestic)govt. paper, TBs etc. The
treatment of foreign govt. paper has been left to individual country
discretion.
b) Qualifying : including securities of multilateral development banks
and public sector entities plus other securities (which are rated by at
least 2 approved rating agencies ) as investment grade, as also
unrated securities which are listed on a recognised stock exchange.
c) Others

The specific risk charge on these securities is as per the following table.

Security Type Residual maturity Risk charge

Govt. All 0%
Qualifying 6 months 0.25%
6 to 24 months 1.00%
24 months 1.60%
Others All 8%

General market risk is designed to capture risks arising from movements in

market interest rates. The capital charge for general market risk is permitted to
be calculated by either the “maturity” or the “duration” method.

Foreign Exchange Risk:

Under the standardised method, the calculation of forex risk is quite simple.
1. For each currency we net all the short and long positions and note
whether the sum is a short or long position.
2. Next, the net position in each currency is converted to domestic
currency.
3. All the short positions in different currencies are added , as also all the
long positions. The larger of these two sums we call as C1.
 4. The net position in gold (whether short or long ) is denoted as C2.

The capital charges are then simply 8% of (C1 plus C2).

As an example, suppose an Indian bank has exposures in the following
currencies and gold (short positions are denoted with a minus sign, while long
positions are with a plus sign)

US$ Stg Euro Gold

Net position -150 $ +200 stg +60 euros -80 $
Net position in -7200 +1400 +2700 -3800
Rs.
The aggregate long position is Rs.4100
The aggregate short position is Rs. 7200
The aggregate short position in gold is Rs.3800
Hence capital charge is 8% of (7200+3800) = Rs 8.80

Market Risks : IRB Approach:

Just as in the case of credit risks, banks are also allowed to base market risk
charges, on their own internal models. Once again, conditions similar to those
listed for the IRB credit approach have to be satisfied. Additionally, for market
risks, a process called stress testing, has also to be included

The crucial input in the IRB approach is a VaR (value-at-risk) model. Basically, a
VaR estimate is simply an appropriate percentile of the bank’s portfolio loss
distribution. The 99% VaR, for example, is the loss magnitude, which will be
exceeded only with 1% probability. Stated otherwise if the 99% VaR of a bank
portfolio is $200,000 then it means that we can assert with 99% confidence
that the bank’s losses from this portfolio will be less than $200,000.

The 3 crucial concepts in a VaR are:

1. The confidence coefficient (whether 95%, 99%, or 99.9%)

2. The historical period, used for estimating the model
3. The holding period, i.e. the period over which the portfolio is considered
to be held constant. Portfolios cannot be adjusted instantaneously
because of transaction costs, lock-in periods etc.
The Basel Accord II proposes a confidence coefficient of 99%, a holding period
of 10 days, and a historical period of observation of at least 1 year.

Additionally, the data set must be updated at least once every quarter.

The VaR estimate has to be computed on a daily basis, incorporating additional

information becoming available on a daily basis.

Each bank must meet on a daily basis, a capital requirement expressed as the
higher of the following 2 factors :

1. Previous days VaR estimate

2. (An average of the VaR of the preceding 60 business days ) m

Here m is a multiplication factor set as

m=3+

where the plus factor is related to the performance of the particular bank’s
VaR model. The value of can range from 0 (exceptionally good performance)
to 1 ( poor performance).

Stress testing is an important dimension of the IRB approach. Specifically this

involves subjecting the model to types of simulated shocks.

1. Changes in assumptions about observed correlations and volatilities,

working on worst possible scenario alternatives.

2. Conducting contra-factuals against past episodes of market turmoil.

Operational Risk

Basel Accord II also offers rather tentative suggestions on the treatment of

operational risk.

As in the case of the other 2 types of risks, a standardised approach as well as

an IRB seem to be acceptable. Both approaches are based on a two-fold
classification – by business units and business lines, as per the following table.

Standardised Approach:

The standardised approach takes cognisance of the different character of

business lines within a bank. It also recognises that the appropriate indicator
for calculating operational risk, for each line of business, could be different.
However, the regulatory charges for each business line are determined by the
regulator.

In determining the regulatory charges, the concept of relative weights is

introduced. These are supposed to reflect the relative importance of the
specific business line within the banking business as a whole. Because the
relative importance of the business lines, is country-specific, the BCBS only lays
down a range of relative weights for each class – the exact weight being left to
the discretion of the national supervisor.
The next step is to calculate a risk factor , which measures the relationship of
the industry’s loss experiences and the broad financial indicator selected.
This factor is of course varying with each line of business. For any specific line
of business it is defined as

=
(20%) (relative weight of business line)
relevant financial indicator over all banks in the country sample

The regulatory capital charge for a bank is now simply

(appropriate indicator) where the summation is over all the business

lines of the bank.

Apart from the standardised approach, the BCBS also recognises in principle
that certain banks could be allowed to develop their own internal models of
operational risk. However, at the moment, no firm guidelines on this seem to
be available.

Buiness Units Business Lines Indicator Relative weights

Inv. Banking Corporate Gross Income 8-12%
Finance
Trading & Gross Income 15-23%
Sales

Banking Retail Banking Annual Average 17-25%

Assets
Commercial Annual Average 13-20%
Banking Assets
Payment & Annual Settlement 12-18%
Settlement
RECENT FINANCIAL CRISIS ANR ROAD TOWARDS BASEL III

Recently Basel II risk based capital requirements have been widely

criticized following the argument that they could exacerbate financial
cycles or more generally business cycle fluctuations (Kashyap and Stein,
2004; Adrian and Shin, 2007, 2008; Plantin, Sapra and Shin, 2008;
Rochet, 2008; Bec and Gollier, 2009, a recent and exhaustive survey of
literature is Drumond, 2009).

This aspect of these regulations has raised some concerns because it may
enhance the procyclical tendencies. The term “procyclicality” is generally
used to refer to mutually reinforcing mechanisms through which the
financial system can amplify fluctuations and possibly cause or
exacerbate financial instability (FSB, 2008).

It has been argued that in the presence of an imperfect market for bank
capital, if during recession, bank borrowers are downgraded by credit
risk models in use; minimum capital requirements will increase. Since it is
difficult or costly for banks to raise external capital in bad times, this co-
movement in bank capital requirement and the business cycle may
induce banks to further reduce lending during recessions, thereby
amplifying the initial downturn.
 The recent instability in the financial markets all over the world has led
the procyclicality issue to enter the agendas of several international fora
such as the G20. According to the Action Plan agreed in the Washington
meeting of G20 held in November 2008, the International Monetary
Fund (IMF), the Financial Stability Board/ Financial Stability Forum
(FSB/FSF) and other regulatory bodies should develop recommendations
to mitigate procyclicality, including the review of how bank capital may
exacerbate cyclical tendencies (Drumond, 2009).

FSF has in its report on addressing procyclicality in the financial system

identified three areas as priorities for policy action: the capital regime,
bank provisioning practices and the interaction between valuation and
leverage. The overview of the recommendations is the following.

Recommendations on bank capital

I. Countercyclical capital buffers

The Basel Committee on Banking Supervision (BCBS) should strengthen the
regulatory capital framework so that the quality and level of capital in the
banking system increase during strong economic conditions and can be drawn
during periods of economic and financial stress.

II. Revamping VaR-based capital estimates

The BCBS should revise the market risk framework of Basel II to reduce the
reliance of cyclical VaR-based capital estimates.

III. Supplementary measure to contain leverage

The BCBS should supplement the risk based capital requirement with a simple,
non-risk based measure to help contain the buildup of leverage in the banking
system and put a floor under the Basel II framework.

IV. Use of stress testing in validating capital buffers

Supervisors should use the BCBS enhanced stress testing practices as critical
part of the Pillar 2 supervisory review process to validate the adequacy of
banks’ capital buffers above the minimum regulatory capital requirement.

V. Monitoring capital procyclicality

The BCBS should, on continuing basis, monitor the impact of the Basel II
framework and make appropriate adjustments to dampen excessive cyclicality
of the minimum capital requirements. The BCBS should, on a continuing basis,
carry out regular assessments of the risk coverage of the capital framework in
relation to financial developments and banks’ evolving risk profiles and make
timely enhancements.

Recommendations on bank provisions

I. Scope for judgment in existing standards

The US Financial Accounting Standards Board (FASB) and International
Accounting Standards Board (IASB) should issue a statement that reiterates for
relevant regulators, financial institutions, and their auditors that existing
standards require the use of judgment to determine an incurred loss for
provisioning of loan losses.

II. Enhancements to loan loss provisioning standards

The FASB and IASB should reconsider the incurred loss model by analyzing
alternative approaches for recognizing and measuring loan losses that
incorporate a broader range of available credit information.

III. Provisioning and Basel II

The BCBS should undertake a review of Basel II to reduce or eliminate
disincentives for establishing appropriate provisions for loan losses. The BCBS
should undertake a review of Basel II to assess the adequacy of disclosure of
loan loss provisioning under Pillar 3.

Recommendations on leverage and valuation

I. Quantitative indicators and constraints on leverage

Authorities should use quantitative indicators and/or constraints on leverage
and margins as macroprudential tools for supervisory purposes.

II. Measuring funding and liquidity risk

The BCBS and the Committee on the Global Financial System (CGFS) should
launch a joint research program to measure funding and liquidity risk attached
to maturity transformation, enabling the pricing of liquidity risk in the financial
system.

III. Data collection on leverage and maturity mismatches

Based on the conclusion of the above research program, the BIS and the IMF
could make available to authorities information on leverage and on maturity
mismatches on a system-wide basis.
 IV. Possible accounting enhancements
Accounting standard setters and prudential supervisors should examine the use
of valuation reserves or adjustments for fair valued financial instruments when
data or modeling needed to support their valuation is weak. They should
examine possible changes to relevant standards to dampen adverse dynamics
potentially associated with fair value accounting.