Implementation of Basel II - Pillar I standardised approach

Basel II is made up of three Pillars. Pillar I involves the calculation of minimum capital requirements to cover credit risk, market risk and operational risk. (The New Zealand Basel I capital framework covers just credit risk). Pillar II covers capital for other risks and overall capital adequacy, and Pillar III covers disclosure.

Our policy document on the standardised approach to Pillar I of Basel II can be read here: "Capital Adequacy Framework (Standardised Approach) BS2A" (PDF 324KB).

Banks using the standardised approach will be subject to conditions of registration that will require capital adequacy to be calculated using the framework set out in "Capital Adequacy Framework (Standardised Approach) BS2A". For those banks, this document will replace the existing BS2 which is based around Basel I.

General background

Basel II places more emphasis than Basel I on the sensitivity of capital to underlying risks, and the incorporation into capital adequacy of risks other than credit risk. Background material on the objectives and general direction of Basel II is available on the website of the Bank for International Settlements at:

http://www.bis.org/publ/bcbsca.htm.

The proposed capital adequacy framework for banks adopting the standardised approach has been made broadly consistent with the approach taken in Australia by the Australian Prudential Regulation Authority (APRA). However, there are differences in some areas between APRA's approach and our proposals, because of differences in the legal framework, the recognition of capital instruments, and the disclosure regimes. Background material on how Basel II will be implemented in Australia is available on the website of APRA.

Proposed implementation of standardised approach in New Zealand

This note contains only a high-level summary of the main features of the standardised approach to Pillar I. The detailed methodology is set out in the BS2A document.

Credit risk

There is greater differentiation of credit risks under the Basel II standardised approach compared to Basel I. Under Basel II, determining the correct risk weight for a particular asset takes into account different criteria and more potential "risk buckets" exist.

Under Basel II, credit assessments from approved credit rating agencies are used where possible in determining the risk weights assigned to exposures in the calculation of capital requirements. For all credit exposures that are assessed, the risk weight is dependent on the level of the assessment (i.e. the credit rating). Under the standardised approach banks use specific assessment aligned risk weights for exposures to sovereigns and central banks, public sector entities and corporates.

The use of inferred assessments is also permitted in certain circumstances. That is, if a particular exposure is not assessed, the exposure may be treated as if it were assessed if it fits the specified criteria. For example, an inferred assessment can be used on a specific exposure if that claim ranks at least pari passu with another exposure of the same type to the same borrower that is assessed.

Initially, the Reserve Bank will accept the use of credit assessments from the three agencies that it has already approved for other purposes (Standard & Poor's, Moody's, and Fitch).

There is also more differentiation among residential mortgage exposures under Basel II than under Basel I. The risk weight for an individual exposure is dependent on the loan-to-valuation ratio, whether the loan is subject to mortgage insurance and whether or not the loan is past-due. Whereas under Basel I all fully secured residential mortgages were risk weighted at 50%, under Basel II the risk weight ranges from 35% to 100%, depending on the above factors.

The loan-to-valuation ratio at any point in time is defined as the ratio of:

  • The current value of all claims secured by way of first ranking mortgage over the residential property plus all undrawn commitments to the borrower which when drawn down will be secured by way of first ranking mortgage over the residential property;

to

  • the valuation of the residential property at the time of the origination of the loan.

Off-balance sheet exposures such as guarantees are converted to credit equivalent amounts using credit conversion factors, and then multiplied by an appropriate risk weight.

Bilateral netting may be used in the calculation of both on- and off-balance sheet exposures, where a satisfactory bilateral netting contract is in place between the bank and a specific counterparty.

There are two methods of credit risk mitigation that may be used under the standardised approach in the case of collateralised exposures – the simple method or the comprehensive method. In the simple method the risk weight of the collateral is substituted for the risk weight of the counterparty. The comprehensive method allows fuller offset of collateral against exposures by reducing the exposure by the adjusted value of the collateral (the required adjustment takes into account possible future changes in the value of the exposure and the value of the collateral). For banking book exposures either method may be used (for the entire banking book), but for trading book exposures where collateral is pledged against counterparty risk, the comprehensive method must be used. In the case of guarantees, under either the comprehensive or simple methods, that portion of the exposure covered by an eligible guarantee may be assigned the risk weight of the protection provider. In the case of credit derivatives there are specific requirements that must be met before a credit derivative can be used for credit risk mitigation purposes – these requirements are set out in detail in BS2A.

Market risk

Market risk is the risk of economic loss arising from adverse movements in interest rates, equity prices and exchange rates. Under Basel II - Pillar I capital must be held against market risk.

The total capital charge for market risk exposure under Basel II is the sum of the aggregate capital charge for equity exposures, the aggregate capital charge for foreign currency exposures, and the aggregate capital charge for interest rate exposures for all currencies.

Operational risk

Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. It includes legal risk, but excludes strategic and reputational risk.

For the purposes of measuring exposure to operational risk, activities must be divided into two categories:

  • retail and commercial banking; and
  • all other activities.

Capital requirements for operational risk arising from retail and commercial banking activities are calculated by multiplying gross retail and commercial loans by a fixed factor. Capital requirements for all other activities that give rise to operational risk are calculated by multiplying gross income from other activities by a fixed factor.