| Cooking with Basel II |
| International Convergence of Capital Measurement and Capital Standards |
The Basel Committee on Banking Supervision of the Bank for International Settlements
(BIS) has issued its June 2006 update. The complete document is available on the BIS
website (www.bis.org). The document is comprehensive but does not, on first
reading, lend itself to straightforward interpretation. To me, it is like a cookbook
where the recipes' ingredients are not stated at the top of the recipes (I'll use this
analogy below). Hence, the title of the page: Cooking with Basel II.
What I have done is to separate the market risk, credit risk and operational risk
sections and parse the relevant paragraphs. When done, the document content
becomes more transparent. I present the results below.
Caveats to avoid legal entanglements:
(BIS) has issued its June 2006 update. The complete document is available on the BIS
website (www.bis.org). The document is comprehensive but does not, on first
reading, lend itself to straightforward interpretation. To me, it is like a cookbook
where the recipes' ingredients are not stated at the top of the recipes (I'll use this
analogy below). Hence, the title of the page: Cooking with Basel II.
What I have done is to separate the market risk, credit risk and operational risk
sections and parse the relevant paragraphs. When done, the document content
becomes more transparent. I present the results below.
Caveats to avoid legal entanglements:
- The presentation that follows is not sanctioned by BIS or the Basel Committee.
- This presentation represents my personal opinion and interpretation of the Basel II
document. - I assume no responsibility for misstatements, misinterpretations or misunderstandings.
| Market Risk |
The Committee's definition of Market Risk is "the risk of loss in on- and
off-balance sheets positions arising from movements in market prices".
The Committee is focused on market risk pertaining to interest-related
instruments and equities in the trading book, and all foreign exchange
and commodities risks.
off-balance sheets positions arising from movements in market prices".
The Committee is focused on market risk pertaining to interest-related
instruments and equities in the trading book, and all foreign exchange
and commodities risks.
To demonstrate the recipe analogy, I'll start at the bottom of a hierarchy of
definitions directly from the Basel II document to derive the ingredients necessary to
bake this cake. Click here to go right to the recipes without the ingredient list.
Note the paragraph numbers referring to the Basel II document.
definitions directly from the Basel II document to derive the ingredients necessary to
bake this cake. Click here to go right to the recipes without the ingredient list.
Note the paragraph numbers referring to the Basel II document.
Financial Asset
- cash, the right to receive cash or another financial asset (circular
definition); OR - the right to exchange assets on potentially favorable terms; OR
- an equity instrument.
Financial Liability
- obligation to deliver cash or another financial asset; OR
- to exchange financial liabilities (another circular definition) under
conditions that are potentially unfavorable.
Financial Instrument
- a contract that gives rise to a financial asset of one entity; AND
- a financial liability or equity instrument.
Positions held with trading intent
- positions held intentionally for short term resale and/or with intent of
benefiting from expected short term price movements or to lock in
arbitrage profits.
Trading Book
Consists of the following:
Consists of the following:
- positions in financial instruments and commodities which are
- held with intent to trade; OR
- to hedge other elements of the trading book.
- the positions must be tradable (without restrictive covenants) or
able to be completely hedged. - the positions must be frequently and accurately valued (see
valuation methodology). - the portfolio must be actively managed.
Capital Charges for foreign exchange risk and for commodities risk
apply to the enterprise's total currency and commodities positions.
apply to the enterprise's total currency and commodities positions.
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| Documenting policies and processes |
The organization must have clearly defined policies and
procedures for:
Compliance with these policies and procedures must be fully
documented and subject to periodic internal audit.
procedures for:
- determining which exposures to include in, and exclude
from, the trading book for purposes of calculating their
regulatory capital; AND - to ensure compliance with criteria for the trading book
and taking into account the risk management
capabilities and practices.
Compliance with these policies and procedures must be fully
documented and subject to periodic internal audit.
Basel II states that Prudent Valuation practices include:
- establishment and maintenance of systems and controls
to provide valuation estimates that are prudent
(circular?) and reliable; AND - must be integrated with other risk management systems
within the organization; AND - must have clear documentation detailing these systems
and controls.
The valuation methodologies can be either:
- mark-to-market (usually using the more prudent side
of any bid/offer values unless the organization is a
market maker in a particular position type); OR - mark-to-model (defined as a valuation which has to
be benchmarked, extrapolated or otherwise
calculated from market input). Used when mark-to-
market is not possible.
Capital Charges apply to the trading book components which will be
prudently valued.
prudently valued.