Banking - the Basil framework of capital requirements - the three pillars

Question 1

What is pillar I of the three Basel pillars?

Answer 1

Minimum capital and liquidity requirements

Question 2

What is pillar II of the three Basel pillars?

Answer 2

Supervisory review

Question 3

What is pillar III of the three Basel pillars?

Answer 3

Market discipline

Question 4

What are the three pillars in regards to Basel?

Answer 4

1. Minimum capital and liquidity requirements
2. supervisory review
3. market discipline

Question 5

Explain the first pillar of Basel pillars

Answer 5

The goal is financial satiability

It sets out minimal capital requirements to meet potential losses caused by credit-, market- or operational risk and also minimum liquidity requirements

Question 6

What is the minimum capital requirement according to pillar 1?

Answer 6

total capital ration at least 8%

Question 7

How do you calculate if the total capital ratio and what dose it have to be?

Answer 7

TCR = Own funds/risk-weighted exposure amounts >= 8%

Question 8

How is the definition of own funds in regards to pillar I

Answer 8

Its not equity in the classical sense

own funds are tier 1 capital + tier 2

Question 9

What are tier 1 assets?

Answer 9

They can be split in 2

Common equity tier 1 and additional tier 1 capital

Question 10

Taking into account the definition of own funds in regards to pillar I is there neccesary split that has to be achieved in regards to tier 1 and tier 2 assets?

Answer 10

Yes, tier 1 has to be at least 6%

Common equity capital ratio at least 4,5%

Question 11

how do you calculate the risk weighted exposure assets to insert into the TCR formula?

Answer 11

Credit risk + market and operational risk * 12,5

Question 12

What is credit risk?

Answer 12

The risk that a bank will incur losses because a counterparty does not pay back a loan.

different types of assets have different risk-weighting depending on the inherent, potential credit risk

Loans to governments are 0% for example while housing loans can be 35%

Question 13

how does the standardized approach work in regards rating methods and risk weight?

Answer 13

I believe the icelandic banks use the standardized approach

you get external rating - credit info for example

and the risk weight is prescribed

for example:
A+ rating
100 USD loan
risk wight for A+ is 50%
the risk weighted asset is therefore 50
50x8% = 4,0

Question 14

What is market risk?

Answer 14

Risk that a bank incurs losses on positions arising from movements in traded assets for example. commodity prices, bonds, stocks and such

Question 15

What is operational risk?

Answer 15

Risk that a bank incur losses from inadequate or failed internal processes, people or systems, or external events.

The standardized approach for minimal capital requirements here is that a bank is split into 8 business lines and the the minimum requirement would be 12%, 15% or 18% of gross income of each line

Question 16

How do the liquidity requirements work according to pillar I

Answer 16

Banks must have sufficient high-quality liquid assets to withstand a 30-day stressed funding scenario that is specified by supervisors

Question 17

Tell me about the capital buffers in pillar I

Answer 17

Basel III introduced a requirement to hold capital buffers in addition to other own fund requirements for the purpose to ensure that banks accumulate, during periods of economic growth, sufficient capital base to absorb losses in stressed periods

Question 18

What type of capital buffers are in pillar I

Answer 18

Capital conservation buffer

countercyclical capital buffer - LÆRA AÐ BERA ÞETTA FRAM

Then we have additional buffers for systemically important institutions

MS can additionally introduce a requirement of a systemic risk buffer to cover structural or systemic risks

Question 19

pillar II has to do with supervisory review - there are 2 review processes what are they?

Answer 19

ICAAP - Internal capital adequacy assessment process

SREP - Supervisory review and evaluation process

Question 20

Explain ICAAP

Answer 20

An institutions strategies and processes to assess and maintain on an ongoing basis the internal capital that they consider adequate to cover risks - presented to the CA

Question 21

Explain SREP

Answer 21

CA reviews the ICAAP from the institution and can take appropriate supervisory action if they are not satisfied with the result of the process.

Question 22

Pillar II can be broken down into 5 main objectives - what are they?

Answer 22

1 - ICAAP
Banks should have process for assessing their overall capital adequacy in relation to their risk profile and strategy for maintaining their capital levels

2 - SREP
Supervisors should review and evaluate the banks internal capital adequacy assessments and strategies and the banks ability to monitor and ensure compliance with regulatory capital ratios

3 - Appropriate action
Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process

4 - Expectations for banks
Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum

5 - early stage intervention
Supervisors should seek to intervene at an early stage to prevent capital from falling bellow the minimum levels required to support the risk characteristics of a particular bank and should require rapid action if capital is not maintained or restored

Question 23

What is the purpose of pillar III

Answer 23

to complement the minimum capital requirements of pillar I and the supervisory review of pillar II

It sets out disclosure requirements which allow market participants to assess key information on the scope of application, capital, risk exposure, risk assessment processes, and hence the capital adequacy of the institution

This is an effective way of informing the market about the banks exposure to risks and enables comparability