International Finance and Accounting Handbook

(avery) #1

(such as Moody’s, S&P, and Fitch IBCA). Both internal ratings approaches require the
bank to formulate and use its own internal credit risk rating system. The risk weight
assigned to each commercial obligation is based on the ratings assignment (either ex-
ternal or internal), so that higher (lower) rated, high (low) credit quality obligations
have lower (higher) risk weights and therefore lower (higher) capital requirements,
thereby eliminating the incentives to engage in risk shifting and regulatory abitrage.
Whichever of the three models is chosen, the BIS II proposal states that overall
capital adequacy after 2005 will be measured as follows:^10


Regulatory Total = Credit Risk + Market Risk + Operational Risk
Capital Capital Requirement Capital Requirement Capital Requirement


where:


1.The Credit Risk Capital Requirement depends on the bank’s choice of either the
Standarized or the Internal Ratings–Based (Foundation or Advanced) Ap-
proaches.
2.The Market Risk Capital Requirement depends on the bank’s choice of either
the Standardized or the Internal Model Approach (e.g., RiskMetrics, historical
simulation, or Monte Carlo simulation). This capital requirement was intro-
duced in 1996 in the European Union (EU) and in 1998 in the United States.
3.The Operational Risk Capital Requirement (as proposed in 2001) depends on
the bank’s choice among a basic Indicator Approach, a Standardized Approach,
and an Advanced Measurement Approach (AMA).^11 While part of the 8% ratio
under BIS I was viewed as capital allocated to absorb operational risk, the pro-
posed new operational risk requirement (to be introduced in 2006) aims to sep-
arate out operational risk from credit risk and, at least for the basic Indicator
Approach, has attempted to calibrate operational risk capital to equal 12% of a
bank’s total regulatory capital requirement.^12 Specifically, on November 5,
2001, the BIS released potential modifications to the BIS II proposals that re-
duced the proposed target of operational risk capital as a percent of minimum
regulatory capital requirements from 20% to 12%.

BIS II incorporates both expected and unexpected losses into capital requirements,
in contrast to the market risk amendment of BIS I, which is concerned only with un-
expected losses. Thus, loan loss reserves are considered the portion of capital that cush-
ions expected credit losses, whereas economic capital covers unexpected losses. BIS
(2000)^13 sound practices for loan accounting state that allowances for loan losses (loan


3.1 INTRODUCTION 3 • 3

(^10) McKinsey estimates that operational risk represents 20%, market risk comprises 20%, and credit
risk 60% of the overall risk of a typical commercial bank or investment bank. See Hammes and Shapiro
(2001), p. 106.
(^11) The Basic Indicator Approach levies a single operational risk capital charge for the entire bank, the
Standardized Approach divides the bank into eight lines of business, each with its own operational risk
charge, and the Advanced Measurement Approach (AMA) uses the bank’s own internal models of oper-
ational risk measurement to assess a capital requirement. See BIS (2001c).
(^12) For more details on the market and operational risk components of regulatory capital requirements,
see the BIS Web site http://www.bis.org.
(^13) p. 4.

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