The New Basel Capital Accord Glossary of Terms Backtesting

Operational risk

Basel Committee on Banking Supervision (BCBS)

Pillar 1 Pillar 2

Basel I

Pillar 3

Basel II Capital Adequacy Directive (CAD)

Qualifying revolving exposures [ from CAD3]

Cook ratio

Probability of default (PD)

Credit conversion factors (CCFs)

Regulatory capital

Credit risk

Risk-Adjusted Performance Measure (RAPM)

Credit risk mitigation

Risk-Adjusted Return on Capital (RAROC)

Economic capital Expected loss (EL)

RARORAC (Risk Adjusted Return on Risk Adjusted Capital)

Exposure at default (EAD)

Risk-weighted assets (RWA)

Future Margin Income (FMI) Interest rate risk

Standardised Approach [for credit risk]

Internal Rating Based (IRB) Approach

Stress test

International Accounting Standards (IAS)

Tier 1 Capital Tier 2 Capital

Loss given default (LGD)

Tier 3 Capital

Market risk New Basel Capital Accord (Basel II)

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Backtesting

Statistical process for validating the accuracy of a VaR model. Banking regulators require backtesting for banks that use VaR for regulatory capital. It involves a comparison between the number of times the VaR model under-predicts the subsequent day's loss, versus the number of time such an under-prediction is expected. If losses exceeding VaR have a 1 in 100 chance of occurring, then we expect to see 2 or 3 of those in a year.

Basel Committee on Banking Supervision (BCBS)

A committee of central banks and bank supervisors/regulators from the major industrialized countries that meets every three months at the Bank for International Settlements in Basel. The Basel Committee consists of senior supervisory representatives from the G10 countries. They provide broad policy guidelines that each country’s supervisors can use to determine the supervisory policies they apply. The Chairman of the Committee is William J. McDonough, President of the Federal Reserve Bank of New York.

Basel I

See Cook ratio

Basel II

See New Basel Capital Accord

Capital Adequacy Directive (CAD)

The European Directive of 15 March 1993 laying down rules with regard to the own resources of investment firms and credit institutions that came into effect on 1st January 1996. This directive fits into the liberalisation of European financial services. CAD is an agreement to require standard capital provisions for financial intermediaries doing business in the European Union.

Cook ratio

The capital adequacy ratio prescribed by the current Basel Capital Accord (July 1988) under the aegis of the BCBS; it is named after Peter Cooke, who chaired the Committee for over a decade and sometimes also referred to “Basel I”.

Credit conversion factors (CCFs)

Percentages designed to convert the off-balance sheet items to credit equivalent assets. These are then placed in their respective risk-based categories, therefore they are converted to on-balance sheet equivalents. In conclusion, the face value of on item requires to be first multiplied by the relevant conversion factor to arrive at risk-adjusted value of the offbalance sheet item.

Credit risk

The risk resulting from the uncertainty in the counterparty’s ability or willingness to meet its contractual obligations.

Credit risk mitigation

A range of techniques whereby a bank can, partially, protect itself against counterparty default (for example, by taking guarantees or collateral, or buying a hedging instrument).

Economic capital

The capital that a bank holds and allocates internally as a result of its own assessment of risk. It is the amount of available resources needed to absorb unexpected losses with 2

Expected loss (EL)

a reasonable degree of confidence over a specified time horizon. These resources are carefully defined by the regulators, but basically include shareholder capital, accumulated earnings, and long-term subordinated debt. Economic capital differs from the regulatory capital because the confidence level and the time horizon chosen are different. The statistical estimate of average losses across a portfolio used for assessing the credit risk. Provisions should cover the expected losses.

Exposure at default (EAD)

The value of the bank’s exposure at the moment of the borrower’s default. EAD can be different from the initial exposure of the bank, can be less than the full face value because, for example, a part of the loan commitment has not been drawn, special collateral is present, or some derivative operation has been undertaken.

Future Margin Income (FMI)

The amount of income anticipated to be generated by the relevant exposures over the next twelve months that can reasonably be assumed to be available to cover potential credit losses on the exposures (i.e., after covering normal business expenses). FMI must not include income anticipated from new accounts. FMI should be measured net of reserve expenses (provisions) since there is a separate offset available for such reserves (provisions). (BIS)

Interest rate risk

Exposure to loss resulting from a change in interest rates. Hedging strategies are designed to minimize, possibly eliminate, the interest rate risk. For example, it is the possibility of a reduction in the value of a security, especially a bond, resulting from a rise in interest rates.

Internal Rating Based The internal ratings based (IRB) approach, is a fundamental shift in the international capital regulation that allows financial (IRB) Approach institutions to estimate internally the amount of capital needed to support their risks. Only financial institutions that demonstrate the ability to conduct the necessary credit risk analysis will meet the eligibility standards (“minimum requirements”) for implementing the IRB approach. Financial institutions can choose between the "Foundation" and "Advanced" IRB approaches that differ in the extent to which they have to supply the inputs used in calculating the capital requirements. International Accounting rules and procedures developed by the Accounting Standards International Accounting Standards Committee (IASC) that (IAS) standardizes accounting requirements and regulates

financial results calculations for publicly traded companies in the European Union. All EU countries are required to adopt IAS by January 1, 2005. Loss given default (LGD)

The loss on a credit instrument after the borrower has defaulted. It is typically stated as a percent of the Exposure at 3

Market risk

Default and it is one minus the recovery rate. The LGD value is reduced when the loan is “backed” by collateral. The risk of adverse deviations in the marked to market value of the trading portfolio during the period required to liquidate transactions..

New Basel Capital Accord (Basel II)

The Basle Committee on Banking Supervision is working on a new Accord on capital adequacy guidelines that more exactly represent the inherent risks. “Basle II” consists of three main ‘pillars’: Capital requirements based on the internal risk-ratings of individual banks, active supervision process, and information disclosure requirements to enhance market discipline. Supposed to be imposed by 2006.

Operational risk

The risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems, or from external events. It arises from the potential that inadequate information systems, operational problems, breaches in internal controls, fraud, or unforeseen catastrophes will result in unexpected losses.

Pillar 1

The Basel II proposal is based on three mutually reinforcing pillars that allow banks and supervisors to evaluate properly the risks that banks face and which should contribute to safety and soundness in the financial system. Pillar 1 consists of minimum capital requirements - the rules a bank uses to calculate its capital ratio.

Pillar 2

Supervisory review of an institution's capital adequacy and internal assessment process; it intends to ensure that banks follow rigorous processes, they measure their risk exposures properly, and they have sufficient capital to support their risks.

Pillar 3

Market discipline tries to encourage safe and sound banking practices through effective disclosure, requiring banks to disclose publicly key measures related to their risk and capital positions.

Qualifying revolving An exposure which meets all of the following criteria: a. The exposures are revolving, unsecured, and uncommitted exposures [ from (both contractually and in practice). In this context revolving CAD3] exposures are defined as those where customers outstanding balances are permitted to fluctuate based on their decisions to borrow and repay, up to a limit established by the institution. b. The exposures are to individuals. c. The maximum exposure to a single individual in the subportfolio is €100,000 or less. d. The institution demonstrates to its competent authority that unless for small and transient deviations FMI covers at least the sum of expected losses and two standard deviations of the annualised loss rate on the sub-portfolio. In the event of small and transient shortfall in meeting this criterion competent 4

authorities may increase the EL component of capital requirements. e. Data on loss rates and margin income for the sub-portfolio is retained. f. The competent authority concurs that treatment as a qualifying revolving exposure is consistent with the underlying risk characteristics of the subportfolio. Probability of default (PD)

The likelihood that a debt instrument will default within a stated timeframe (Basel -1 year). For example, the probability of default of a certain loan is 2%; this means that there are 2 chances out of 100 that the borrower will default in the next 12 months.

Regulatory capital

The minimum amount of capital imposed by the regulator. It is the sum of Tier 1, Tier 2 and Tier3 capital.

Risk-Adjusted Performance Measure (RAPM)

Method for evaluating a firm’s optimal performance level based on the risk-reword combination, meaning the greatest expected return for a given level of risk or, equivalently, the lowest risk for a given expected return. RAPM consists of the firm’s risk-adjusted return (revenues less expenses less reserves/ provisions allocated to cover expected losses) divided by risk-adjusted capital or the economic capital (capital required to support unexpected losses). Another measure of risk-adjusted profitability that enables management to allocate capital, and the related cost of capital, in respect of credit, market and operational risk by type of transaction, client and line of business. This facilitates the deployment of capital to business units that can provide the maximum shareholder value on the capital invested.

Risk-Adjusted Return on Capital (RAROC)

RARORAC (Risk Adjusted Return on Risk Adjusted Capital)

A combination of Risk Adjusted Return On Capital (RAROC) and Return On Risk Adjusted Capital (RORAC) in which specific risk adjustments are made to the return stream and the capital charge is varied to reflect different expectations of risk in different businesses.

Risk-weighted assets Used in the calculation of risk-based capital ratios. They are the total assets calculated by applying predetermined risk(RWA) weights (set by the regulators) to the nominal outstanding amount of each on balance sheet asset and the notional principal amount of each off-balance sheet item. Standardised Approach [for credit risk]

The Standardised Approach is conceptually identical to the 1988 Accord: the application of a standardised set of riskweights to different categories of on- and off-balance-sheet exposures, but with some additional risk sensitivities. These risk sensitivities are provided by using a slightly wider range of prescriptive risk weights and by linking these risk weights to public ratings instead of the OECD concerns. The standardised approach is targeted at banks desiring a 5

simplified capital framework. Stress test

A measure of the potential loss as a result of a plausible event in an abnormal market environment. Two types of stress testing are popular. The first is based on economic scenarios (for example, you might price your portfolio, using market conditions at the time of the crash of 1987, or assuming a three-standard-deviation move in prices, or a 100year move in the forward curve). The second is "matrix" based (change a bunch of assumptions about correlations and variances and see what happens. Neither is statistical in nature, in contrast to VaR.

Tier 1 Capital

In include shareholders’ equity and retained earnings. This key element of capital is the only element common to all countries' banking systems; it is wholly visible in the published accounts and is the basis on which most market judgments of capital adequacy are made. The bank has to hold at least half of its measured capital in Tier 1 form.

Tier 2 Capital

Additional internal and external resources available to the bank (e.g. undisclosed reserves, general provisions, hybrid capital, subordinated term debt). Each of these elements may be included or not by national authorities, at their discretion, in the light of their national accounting and supervisory regulations.

Tier 3 Capital

In April 1995, the Committee allowed banks, at national discretion, to issue short-term subordinated debt to meet a part of their market risks. It is limited to 250% of a bank’s Tier 1 capital that is required to support market risk.

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