Basle II

The Norme S Basle II (the New Agreement of Basle) constitute a prudential device intended for better apprehending the banking Risque S and mainly the Credit risk or of counterpart and the requirements in equities. These directives were prepared since 1998 by the Committee of Basle, town of Suisse, under the aegis of the “central bank of the central banks”: the Bank for International settlements and led to the publication of the Directive CRD.
The standards of Basle II should replace the standards installation by Basle I and aim in particular to the installation of the Ratio McDonough intended to replace the Ratio Cooke which goes back to 1988.
According to the same groundwork, new standards Solvabilité II are in the course of discussion for the reinsurance and insurance companies.

Agreements of Basle and the Cooke ratio

In 1988, the Comité of Basle, composed of the governors of the central banks of 13 country of OECD publishes the first “Agreements of Basle”, together of recommendations whose pivot is the installation of a minimal ratio of equities compared to all the granted appropriations, the Ratio Cooke.

Thus the concepts are defined of:

lawful Equities;
and of Together of engagements of credit.

These two concepts being rigorously specified compared to a countable System (accounts concerned, possible weightings).

The ratio of the two values should not then be lower than 8% in the proposals of the Agreements of Basle.

It is it should be noted that they are only recommendations, gives the responsability with each Member State (and any other interested state) to transpose them in its own right. Thus, in France is applied since January 1st 1993 the test of solvency European (directive 89/647/CEE of the December 18th 1989), translated in the French right by payment 91-05 of the Comité of the banking and financial regulation and instruction 91-02 of the Bank charge.

The agreements of Basle are currently applied in more than one hundred of country.

Agreements of Basle II and the McDonough ratio

Presentation

Great limit of the Cooke ratio, and thus of the regulations resulting from the first agreements from Basle, is related to the definition of engagements of credit. The principal variable taken into account was rising distributed credit. In the light of the financial Theory modern, it appears that is neglected the essential dimension of the quality of the borrower, and thus of the Credit risk that it really represent.

The Committee of Basle thus will propose in 2004 a new whole of recommendations, at the end whose a more relevant measurement of the credit risk will be defined, with in particular the taking into account of the quality of the borrower, including via a system of notation interns clean with each establishment (called IRB , Internal Rating Based ). The new test of solvency is the Ratio McDonough.

In fact, the recommendations of Basle II rest out of three pillars (term explicitly employed in the text of the agreements):

the requirement of equities (test of solvency McDonough);
procedure of monitoring of the management of equities;
the discipline of the market (transparency in the communication of the establishments).

Pillar I: the requirement of equities

As indicated above, it is the chapter which interests us more; it refines the agreement of 1988 and seeks to return the coherent equities with the risks really incurred by the financial institutions. Among the innovations, let us announce the taking into account of the operational risks (fraud and breakdowns of system) and of the risks of market, in complement of the credit risk or of counterpart.

We pass thus from a Cooke ratio where Capital stock own of the bank > 8% of the credit risks with a McDonough ratio where Capital stock own of the bank > 8% of (credit risks (75%) + of market (5%) + operational (20%))

moreover calculation of the credit risks specifies itself by a finer weighting of incur (incur it balanced = RWA) with a taking into account: risk of defect of the counterpart (the customer borrower) risk on the credit line (standard of credit, duration, guarantee) incur

These risks are expressed by probability: PD = Probability of defect of the counterpart LGD = Rate of loss in the event of defect on the credit line who applies to incur at one year of the customer: the EAD (exposure at the time of the defect)

For the credit risk, the banks can use various mechanisms of evaluation.
The method known as standard consists in using marking systems provided by organizations externes.
The methods more sophisticated (methods IRB for Internal Ratings Based ) with the method known as IRB-Foundation and that known as IRB-Projection imply methodologies internal and suitable for the financial institution of evaluation of dimensions or notes, in order to weigh the relative risk of the credit. Thus of standard method PD and LGD are imposed by the regulator (bank charge in France) either directly for the LGD, or by imposing an organization of notation (Quotation BDF, Standard and poors…) In method IRB foundation, the Bank estimates its PD and the LGD remains imposed by the regulator. In advanced method IRB, the bank controls all its components.

The choice of the method (more or less complex) makes it possible a bank to identify its own risks according to its management. A Bank which would like to be closest to its reality will tend towards the choice of a advanced method. But n the other hand, the investment is all the more important: The determination of a LGD thus requires the management and the historisation of more than 150 monthly data on minimum a five years on each granted appropriation.

The calculation of the credit risk is then simple: RWA= F (PD; LGD) X EAD where F respects a normal law.

It is supplemented calculation of an awaited loss: EL = PDxLGDxEAD Equities In the ratio: --------------------------------------------------------- > 8% Credit risk + operational Risk + Risk of Market

The sum of the RWA of each customer will compose the credit risk, and the EL will come to modify by rules of provisionnings equities.

Pillar II: procedure of monitoring of the management of equities

As the strategies of the banks can vary as for the composition of the credit and the taking risk, the central banks will have more freedom in the establishment of standards vis-a-vis the banks, being able to raise the requirements of capital where they will consider it necessary…

This need will apply in two ways: 1) validation of the statistical methods employed with pillar 1 (back testing) 2) test of validity of equities in the event of economic crisis

1) The bank will have to prove a posteriori the validity of its a priori definite methods according to its statistical data and that over rather long periods (5 to 7 years). It will have moreover to be capable of " tracer" the origin of its data.

2) The bank will have to prove that on its segments of customers, her equities are sufficient to support an economic crisis concerning one or all of these sectors.

The bank charge will be able according to these results imposing the need for additional equities.

Pillar III: the discipline of market

Rules of transparency are laid down as for the information availability of the public on the credit, the risks and their management.

The application of Basle II is a powerful machine which " formate" data of management of a bank.

Its consequences are of three orders on the level of pillar III:

1) Standardization of the banking good practices Whatever the bank and whatever the regulation which governs it (national rights) the practices must be transparent and standardized.

2) The bases installation for this calculation are a powerful data source of management, which (finally) reconcile the sights risks, accountants and financial (finally has minimum, because who will believe that the risk of discount accepted is equivalent to that of Dailly!)

3) financial transparency Finally our analysts will find a reading of the wallets of identical risk for any bank in all countries.

This pillar is more " mark to market" of this reform. This Anglicism which crosses all the text of Basle, and the application of standards IAS, has T it a base apart from the banks of world size? What thinks of it our Nobel Prize of the economy 2006, whose action is the micro credit?

The calendar of installation

With regard to the European Union (and thus the whole of the Member States):

26 June 2004: Publication of the recommendations known as “ Basle II ”
1st January 2006: The finance companies calculate in parallel the Cooke ratio (Basle I) and the ratio McDonough (Basle II)
14 June 2006: Adoption of European directive (known as CRD) of translation of the agreement
1st January 2007: Coming into effect of the European directive for the approaches standards and notation interns foundation
1st January 2008: Coming into effect of the directive for the approach notation interns advanced

See the detail of the calendar in the file Test of solvency on fbf.fr

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