FAQ on Basel II

1.     Why do the developed countries care so much about global capital/accounting norms? Should they not keep that competitive advantage with them? It is NOT a competitive advantage for a single country per se, unless everyone else adopts. Else it becomes a source of competitive advantage, where some national banks may need to set aside less capital than others, and may report higher profits also due to different accounting rules.

2.     Why would some assets have a risk weight over 100%(for example 150% risk weight when provisions are less than 20% of the outstanding amount of the loan)? After all, is not the maximum loss 100% of exposure? Well, when there are derivative positions, liability to fund cash calls etc, then the maximum exposure can top 100%. That is why the weights are there.

3.     How to convert off balance sheet items to credit exposure equivalent? Use credit conversion factors(CCF). These use behavioural finance and subjectively estimated caps.

4.     Why do wholesale banks care so much about accounting? From the capital perspective, banks raise very little capital organically and so depend heavily on capital markets for raising debt/equity. These capital markets look at the financial reporting numbers since that is what they have access to. Other industries(barring highly levered ones) can sustain on organic growth w/o capital markets funding but banks cannot. On the demand side also, areas like hedge accounting affect the type of transactions which risk averse companies will authorize their Treasury function to enter into. That is why banks take an active interest in IFRS.

5.     Why treat the same instrument differently in banking book/trading book? It IS illogical but the presumption is that there are significant constraints on the ability of banks to liquidate banking book positions and value them reliably on a daily basis, and so capital treatment should be difference. Also, the intention driven IAS 39 would account for these instruments differently, and from a risk perspective, market risk is presumed to impact trading book more than it does banking book.

6.     Why do home regulators look at the entire consolidated entity? Is it not going beyond their scope? Not really, they need to capture the risk of the whole banking group for which they need to regulate a consolidate entity.

7.     Why do new banking models initially allow for lesser capital requirement(albeit with a lower cap)? structured to provide incentives for banks to  adopt more sophisticated practices quicker and voluntarily.

8.     Among Potential future exposure (PFE), expected exposure (EE), and expected positive exposure (EPE), why is EPE preferred? By using EPE, transactions with CCR are given the same standing as loans with the goal of reducing the capital treatment’s influence on a firm’s decision to extend an on-balance sheet loan rather than engage in an economically equivalent transaction that involves exposure to CCR.

9.      What is the logic of alpha and Beta scaling factors while converting EPE to EAD? To be consistent with the Revised Framework for credit risk, the EAD for instruments with CCR must be determined conservatively and conditionally on a “bad state” of the economy. To accomplish such conditioning in a practical, pragmatic, and conservative manner, the internal model and standardised methods proposed in this note scale EPE using multipliers, termed “alpha” and “beta”, respectively. This proposal sets alpha at 1.4 for the internal model method and beta at 2.0 for the standardised method