Basel
ii in the United States of America
From the
Basel ii
Compliance Professionals Association (BCPA),
the largest association of Basel ii Professionals in the
world
Final Rule, USA: Risk-Based Capital Standards:
Advanced Capital Adequacy Framework — Basel II
Conceptual Overview
This final rule is intended to produce
risk-based capital requirements that are
more risk-sensitive than those produced
under the agencies’ existing risk-based capital rules (general risk-based capital rules).
In particular,
the IRB approach requires banks to
assign risk parameters to wholesale
exposures and retail segments and provides specific risk-based capital formulas that must be
used to transform these risk parameters into risk based capital requirements.
The framework is
based on “value-at-risk”
(VaR) modeling techniques
that
measure credit risk and operational risk.
Because
bank risk measurement practices are both
continually evolving and subject to
uncertainty, the framework should be viewed as an effort to improve the risk sensitivity
of the risk-based capital requirements for banks, rather than as an effort to produce a
statistically precise measurement of risk.
The framework’s conceptual foundation is
based on the view that risk can be quantified through the estimation of
specific characteristics of the probability distribution
of potential losses over a given time horizon.
This
approach assumes that a suitable estimate of that probability distribution,
or at least of the specific characteristics to be
measured, can be produced.
Figure 1
illustrates some of the key concepts associated with the
framework.
The
figure shows a
probability
distribution of potential losses associated with
some time horizon (for example, one year).
It could
reflect, for example, credit losses, operational losses, or other types of losses.
The area under the curve to the right of a
particular loss amount is the probability of experiencing
losses exceeding this amount within a given time horizon.
The
figure also shows the statistical mean of the
loss distribution, which is equivalent to the amount
of loss
that is “expected” over the time horizon.
The
concept of “expected loss” (EL) is distinguished from that of “unexpected
loss” (UL), which represents potential losses over and
above the EL amount.
A given
level of UL can be defined by reference to a particular
percentile threshold of the probability distribution.
For
example, in the figure
UL is measured at the 99.9th
percentile level and
thus is equal to the value of the loss distribution corresponding to the 99.9th
percentile, less the
amount of EL.
This is shown graphically at the bottom of the figure.
The particular percentile level chosen for
the measurement of UL is referred to as the
“confidence level” or the “soundness
standard” associated with the measurement.
If capital is available to cover losses up to
and including this percentile level, then the bank should
remain solvent in the face of actual losses of that
magnitude.
Typically, the choice of confidence level or soundness
standard reflects a very high percentile level, so
that there is a very low estimated
probability that actual losses would exceed the UL amount associated with that confidence
level or soundness standard.
Assessing risk and assigning regulatory
capital requirements by reference to a specific percentile of a probability
distribution of potential losses is commonly referred to as a VaR approach.
Such an approach was
adopted by the FDIC, Board, and OCC for assessing a bank’s risk-based capital
requirements for market risk in 1996 (market risk rule).
Under
the market risk rule, a bank’s own internal models are
used to estimate the 99th
percentile of the
bank’s market risk loss distribution over a
ten-business-day horizon.
The bank’s market risk capital requirement
is based on this VaR estimate, generally multiplied by a factor of three.
The
agencies implemented this multiplication factor to provide a prudential buffer for market
volatility and modeling uncertainty.
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