Capital Adequacy and Risk Management of The HSBC Limited

Capital Adequacy and Risk Management of The HSBC Limited



Various newspaper articles published in the last few months reveal that Bangladesh Bank, the regulator of the banking industry in Bangladesh, is planning to implement the Basel II accord for the banks in Bangladesh from 2009. Basel II is an effort by international banking supervisors to update the original international bank capital accord (Basel I), which has been in effect since 1988 (in Bangladesh since 1996). Basel II reflects the latest round of deliberations by central bankers held in Basel, Switzerland, where they agreed to ensure uniformity in the way banks and banking regulations approach risk management across national borders. The Basel-II Capital Accord titled “International Convergence of Capital Measurement and Capital Standards: A Revised Framework” has been published by the Bank for International Settlement (BIS) in November 2005 for adoption globally.

The new accord, though complex, carries a lot of virtues and will be a milestone in improving commercial banks’ internal mechanism and supervisory process. It will be beneficial to the commercial banks, as it requires review and measurement of different types of risk, which ultimately have effect on risk management approach to comply with the accord standards. Once implemented, banks would also be benefited with significant improvements in their risk management systems, business models, capital strategies and disclosure standards as well as overall efficiency. At present, Bangladesh is following Basel-I for banks’ capital adequacy requirement, wherein risk-weighted capital adequacy ratio was 8 per cent when it was first adopted in 1996. Later in 2002, the ratio was increased to 9 per cent. The idea of the new framework is to strengthen risk-based requirements by laying out principles for banks to assess the adequacy of their capital. It will also enable the supervisors to review such assessments to make sure that banks have adequate capital to support their risks. It also seeks to strengthen market discipline by enhancing transparency in banks’ financial reporting.

The new Basel accord has been prepared on the basis of three pillars: minimum capital requirement, supervisory review process and market discipline. Three types of risks — credit risk, market risk and operational risk — have to be considered under the minimum capital requirement. For credit risk measurement, new framework provides two different methods – standardized approach and internal ratings-based approach. Implementation of standardized approach requires credit assessment intuitions or rating agencies for determining capital requirements of the banks in line with the Basel fixed risk-weight. On the other hand, internal rating based approach allows banks to rate their credit risks, which again have two different approaches — foundation approach and advanced approach.

However, implementation of Basel II at individual bank’s level is not likely to be an easy task. It will require training for the banking professionals, investment in hard and soft infrastructure and high level professional skill in risk management system implementation. More importantly, it may increase the banks’ capital requirement as the banks’ risk weighted capital adequacy ratio may fall because of more stringent risk assessment and higher risk weights.

This report provides a brief overview of the prevailing status and conditions of the banking sector in Bangladesh in line with Basel II requirements. However, this study has mainly concentrated on the implementation aspects of Pillar I, which has three components such as credit risk, operational risk and market risk. In fact, this study has further narrowed down its scope to focus on different approaches for the measurement of capital charge against credit risk and operational risk and seeks to answer the following questions: (a) What kinds of challenges are likely to be faced by both the Bangladesh Bank and the scheduled banks (including HSBC Bangladesh) in adopting different approaches to credit risk and operational risk? (b) Which approaches are likely to be more appropriate for Bangladesh to measure and charge capital against those risks?


This report tried to achieve the following objectives:

  • Give a brief overview of the Basel II accord and the requirements under this accord.
  • Analyze the advantages and disadvantages of the options available under Basel II to assess different types of risks and predict which methods are likely to be adopted by Bangladesh Bank for implementation by the scheduled banks in Bangladesh.
  • Analyze how the adoption of Basel II accord by Bangladesh Bank will affect the capital adequacy position and existing risk assessment process of HSBC Bangladesh
  • Determine the level of preparedness of HSBC Bangladesh to meet the new requirements and find out the steps the bank should take to minimize these effects.


The report stayed limited only to evaluating the changes that will have to be implemented in risk assessment processes due to the first pillar of Basel II accord, i.e. Minimum Capital Requirement, by Bangladesh Bank and HSBC Bangladesh. It did not focus on the other two pillars, namely Supervisory Review and Market Discipline in detail. Neither did the report attempt to judge the overall impact of Basel II accord on the banking industry of Bangladesh.


The report used both secondary data and primary data. Secondary data was collected and used to provide overview of the Basel II accord and the requirements under this accord, the changes introduced in measuring credit risk, market risk and operational risk etc. Secondary data was also used to determine the suitability of the various alternative risk assessment approaches for implementation in Bangladesh and their likelihood of being selected by Bangladesh Bank. Primary research was done to find out the impact of the proposed changes on capital requirement and risk assessment process of HSBC Bangladesh.

Primary source

Primary data was collected by interviewing concerned officials of the bank in the Financial Control, Credit Risk Management, Operations and Corporate Banking Divisions of HSBC Bangladesh.

Secondary source

The secondary data was collected partly from the Basel II accord itself, i.e. “International Convergence of Capital Measurement and Capital Standards: A Revised Framework” published by the Bank for International Settlement (BIS). Additional data was collected from various newspaper articles, internet articles and Bangladesh Bank publications on the accord. Some data was also collected from the HSBC Group’s intranet to find out the Group’s planned strategy in meeting Basel II requirements.

Data Collection Method

For the organization part and secondary data for the research part, information was collected from different published articles, journals, reports and brochures on HSBC. Primary data for the research part was collected through interviewing the relevant officials of the bank. However, no formal questionnaire for data collection will be used.


Some of the relevant information of the bank is confidential & critical. For this reason, these figures were not available from the bank. In such case, proxy figures was used, if possible, while analyzing many issues related to risk assessment and capital adequacy.

Overview Of HSBC Group

 An Overview of HSBC Group

The HSBC Group is named after its founding member, The Hongkong and Shanghai Banking Corporation Limited, which was established in 1865 in Hong Kong and Shanghai to finance the growing trade between China and Europe.

Thomas Sutherland, a Hong Kong Superintendent of the Peninsular and Oriental Steam Navigation Company helped to establish this bank in March 1865. Throughout the late nineteenth and the early twentieth centuries, the bank established a network of agencies and branches based mainly in China and South East Asia but also with representation in the Indian sub-continent, Japan, Europe and North America.

The post-war political and economic changes in the world forced the bank to analyze its strategy for continued growth in the 1950s. The bank diversified both its business and its geographical spread through acquisitions and alliances.

HSBC Holdings plc, the parent company of the HSBC Group, was established in 1991 with its shares quoted on both the London and Hong Kong stock exchanges. The HSBC Group now comprises a unique range of banks and financial service providers around the globe.

HSBC maintains one of the world’s largest private data communication networks and is reconfiguring its business for the e-age. Its rapidly growing e-commerce capability includes the use of the internet, PC banking over a private network, interactive TV, and fixed and mobile, including wireless application protocol or WAP-enabled mobile, telephones.

   HSBC History

The HSBC Group has an international pedigree, which is quite unique. Many of its principal companies opened for business over a century ago and they have a history rich in variety and achievement.

Foundation and Growth

The inspiration behind the founding of the bank was Thomas Sutherland, a Scot who was then working as the Hong Kong Superintendent of the Peninsular and Oriental Steam Navigation Company. He realized that there was considerable demand for local banking facilities both in Hong Kong and along the China coast and he helped to establish the bank in March 1865. Then, as now, the bank’s headquarters were at 1 Queen’s Road Central in Hong Kong and a branch was opened one month later in Shanghai.

Throughout the late nineteenth and the early twentieth centuries, the bank established a network of agencies and branches based mainly in China and South East Asia but also with representation in the Indian sub-continent, Japan, Europe and North America. In many of its branches the bank was the pioneer of modern banking practices. From the outset, trade finance was a strong feature of the bank’s business with bullion, exchange and merchant banking also playing an important part. Additionally, the bank issued notes in many countries throughout the Far East.

During the Second World War the bank was forced to close many branches and its head office was temporarily moved to London. However, after the war the bank played a key role in the reconstruction of the Hong Kong economy and began to further diversify the geographical spread of the bank.

The post-war political and economic changes in the world forced the bank to analyze its strategy for continued growth in the 1950s. The bank diversified both its business and its geographical spread through acquisitions and alliances. This strategy culminated in 1992 with one of the largest bank acquisitions in history when HSBC Holdings acquired the UK’s Midland Bank plc (now called HSBC Bank plc). However, it remained committed to its historical markets and played an important part in the reconstruction of Hong Kong where its branch network continued to expand.

Table 1: Timeline of Progress: HSBC

Key events in the growth of the HSBC Group


The HSBC Group evolved from The Hongkong and Shanghai Banking Corporation Limited, which was founded in 1865 in Hong Kong with offices in Shanghai and London and an agency in San Francisco.

The group expanded primarily thought offices established in the bank’s name until mid-1950s when it began to create or acquire subsidiaries. The following are some key developments in the Group’s growth since 1959

1959The Hongkong and Shanghai Banking Corporation acquires The British Bank of Middle East (formerly the Imperial Bank of Persia, now called HSBC Bank Middle East Limited).
1965The Hongkong and Shanghai Banking Corporation acquires a majority shareholding in Hang Seng Bank Limited, now the second-largest bank incorporated in Hong Kong.
1971The British Bank of the Middle East acquires a minority stake of 20% in The Cyprus Popular Bank Limited (now trading as Laiki Group)
1972Midland Bank acquires a shareholding in UBAF Bank Limited (now known as British Arab Commercial Bank Limited).
1978The Saudi British Bank is established under local control to take over The British Bank of the Middle East’s branches in Saudi Arabia.
1980The Hongkong and Shanghai Banking Corporation acquires 51% of New YorkState’s Marine Midland Bank, N.A. (now called HSBC Bank USA). Midland acquires a controlling interest in leading German private bank Trinkaus & Burkhardt KGaA (now HSBC Trinkaus & Burkhardt KGaA).
1981Hongkong Bank of Canada (now HSBC Bank Canada) is established in Vancouver. The Group acquires a controlling interest in Equator Holdings Limited, a merchant bank engaged in trade finance in sub-Saharan Africa.
1982Egyptian British Bank S.A.E. is formed, with the Group holding a 40% interest.
1983Marine Midland Bank acquires Carroll McEntee & McGinley (now HSBC Securities (USA) Inc.), a New York based primary dealer in US government securities.
1986The Hongkong and Shanghai Banking Corporation establishes Hongkong Bank of Australia Limited (now HSBC Bank Australia Limited)
1987The Hongkong and Shanghai Banking Corporation acquires the remaining shares of Marine Midland and 14.9% equity interest in Midland Bank plc (now HSBC Bank plc).
1991HSBC Holdings is established; its shares are traded on the London and Hong Kong stock exchanges.
1992HSBC Holdings purchases the remaining equity in Midland Bank.
1993The HSBC Group’s Head Office moves to London.
1994Hongkong Bank Malaysia Berhad (now HSBC Bank Malaysia Berhad) is formed.
1997The group establishes a new subsidiary in Brazil, Banco HSBC Bamerindus S.A. (now HSBC Bank Brasil S.A. – Banco Mǔltiplo), and acquires Roberts S.A. de Inversiones in Argentina (now HSBC Argentina Holdings S.A.).
1999Shares in HSBC Holdings begin trading on a third stock exchange, New York. HSBC acquires Republic New York Corporation (now integrated with HSBC USA Inc.) and its sister company Safra Republic Holdings S.A. (now HSBC Republic Holdings (Luxembourg) S.A.). Midland Bank acquires a 70.03% interest in Mid-Med Bank p.l.c. (now HSBC Bank Malta p.l.c.), Malta’s largest commercial bank.
2000HSBC acquires CCF, one of France’s largest banks. Shares in HSBC Holdings are listed on a fourth stock exchange, in Paris. The Group increases its shareholding in Egyptian British Bank to over 90% and later renames it HSBC Bank Egypt S.A.E.
2001HSBC acquires Demirbank TAS, now HSBC Bank A.S., Turkey’s fifth largest private bank; and signs an agreement to purchase an 8% stake in Bank of Shanghai.
2002Acquisitions include Group Financiero Bital, S.A. de C.V., one of Mexico’s largest financial services groups; and a 10% interest in Ping An Insurance Company of China Limited, the second largest life insurance operations in China.
2003HSBC acquires Household International Inc., a leading US consumer finance company; and Lloyds TSB’s Brazilian assets including Losango Promortora de Vendas Ltd, a major consumer credit institution. Four French private banking subsidiaries combine to form HSBC Private Bank France. HSBC Insurance Brokers Limited forms a joint venture, Beijing HSBC Insurance Brokers Limited, in which it has a 24.9% stake.

Hang Seng Bank acquires 15.98% of Industrial Bank Co Ltd, a mainland China commercial bank, and HSBC agrees to purchase 50% of Fujian Asia bank Limited (no Ping An Bank Limited).

2004HSBC acquires The Bank of Bermuda Limited, a leading provider of fund administration, trust, custody, asset management and private banking services; and shares in HSBC Holdings are listed on a fifth stock exchange, in Bermuda.
2005HSBC marked 140 years in China by increasing its stake in the country. In the Middle East, HSBC reopened its branch in Kuwait, while in the USA, the integration of Household International with the Group’s North American operations was completed, under the name ‘HSBC Finance Corporation’.

HSBC Asset Management, HSBC Investment Management and HSBC Multi-manager become HSBC Investments. HSBC Halbis Partners, a specialist fundamental active investment business is formed from part of HSBC Asset Management and all of HSBC Alternative Investments.

2006HSBC acquires Bank of Panama for USD 1.77 billion to increase its presence in South America. Currently the Group has presence in 76 Countries worldwide.

The HSBC Group at present

HSBC Holdings is a public limited company incorporated in England and Wales. Headquartered in London, the HSBC group operates in five regions: Europe; Hong Kong; the rest of Asia Pacific; including the Middle East and Africa; North America; and South America. The entities which form the HSBC Group provide a comprehensive range of financial services to personal, commercial, corporate, institutional and investment, and private banking clients. To more easily promote the Group as a whole, HSBC was established as a uniform, international brand name in 1999. In 2002, HSBC launched a campaign to differentiate its brand from those of its competitors by describing the unique characteristics which distinguish HSBC, summarized by the words ‘The world’s local bank’.

  Banks under the HSBC Group

Many of the members of the group have changed their name into HSBC (The Hong Kong and Shanghai Banking Corporation Limited) to introduce the whole group under one brand name.

Midland Bank, one of the principal UK clearing banks, was acquired by HSBC Holdings in 1992. The bank has a personal customer base of five and a half million, business customers of over half a million, and a network of almost 1,700 branches in the United Kingdom. Midland has offices in 28 countries and territories, principally in continental Europe, with a number of offices in Latin America.

Hang Seng Bank, in which HongkongBank has a 62.1% equity interest, maintains a network of 146 branches in the Hong Kong SAR, where it is the second-largest locally incorporated bank after HongkongBank. Hang Seng Bank also has a branch in Singapore and four branches in China.

Marine Midland Bank, headquartered in Buffalo, New York, has 380 banking locations state-wide. The bank serves over two million personal customers and 120,000 commercial and institutional customers in New YorkState and, in selected businesses, throughout the United States.

Hongkong Bank of Canada is the largest foreign-owned bank in Canada and the country’s seventh-largest bank. It has 116 branches across Canada and two branches in the western United States.

Banco HSBC Bamerindus was established in Brazil in 1997. The bank has its head office in Curitibank and a network of some 1,900 branches and sub-branches, the second largest in Brazil.

Hongkong Bank Malaysia is the largest foreign-owned bank in Malaysia and the country’s fifth-largest bank, with 36 branches.

The British Bank of the Middle East (British Bank) is the largest and most widely represented international bank in the Middle East, with 31 branches throughout the United Arab Emirates, Oman, Bahrain, Qatar, Jordan, Lebanon and the Palestinian Autonomous Area, including an offshore banking unit in Bahrain. The bank also has branches in Mumbai and Trivandrum, India, and Baku, Azerbaijan, as well as private banking operations in London and Geneva.

HSBC Banco Roberts was acquired in 1997. Based in Buenos Aires, it is one of Argentina’s largest privately owned banks, with 60 branches throughout the country.

HongkongBank of Australia has 16 branches across Australia. It is the flagship of the HSBC Group’s businesses there, operating under the name HSBC Australia, and providing a complete range of financial services.

The Saudi British Bank, a 40%-owned member of the HSBC Group, has 63 branches throughout Saudi Arabia and a branch in London.

Other associated Group banks are British Arab Commercial Bank, The Cyprus Popular Bank and Egyptian British Bank. Wells Fargo HSBC Trade Bank is a San Francisco-based joint venture between HSBC and Wells Fargo Bank, providing trade finance and international banking services in the United States through its offices in five western states and in conjunction with Wells Fargo’s 32 regional commercial banking offices in 10 western states. In addition, the Group has a non-equity strategic alliance with Wells Fargo Bank, which provides access to a wide range of banking services through that bank’s more than 1,900-staffed outlets. The Group also has a non-equity alliance with Wachovia Corporation, one of the leading corporate banks in the United States, with business relationships in 50 states.

HSBC’s International Network

The HSBC Group’s international network comprises of some 9,500 offices in 76 countries and territories. A brief list is presented below:






Country Classifications

To ensure that the key resources (management time, capital, human resources and IT) are correctly allocated and that the exchange of best practice is accelerated between entities, the group has classified the countries where it operates into 3 categories: the large, the major and the international.

These classifications are a function of sustainable, attributable earnings, the number of retail clients, balance sheet and size of operation. A brief presentation of this classification is shown below:



   HSBC Brand & Corporate Identity

A key part of the Group’s business strategy, announced in 1998, is the creation of a global brand featuring the HSBC name and hexagon symbol. The symbol is now a familiar sight around the world. The Group has embarked on the next phase — making the HSBC brand universally synonymous with its core values of integrity, trust and excellent customer service.

The Hexagon logo of HSBC is derived from HSBC’s traditional flag, a white rectangle divided diagonally. Like many other Hong Kong company flags in the last century, the design of the flag was based on the cross of St. Andrew, The Patron Saint of Scotland.

HSBC presents it self as a prudent, cost conscious, ethically grounded, conservative, trustworthy international builder of long-term customer relationships.

 HSBC Vision Statement

“We aim to satisfy our customers with high quality service that reflects our global image as the premier international bank”

Objectives of HSBC

HSBC’s objectives are to provide innovative products supported by quality delivery of systems and excellent customer services, to train and motivate staff and to work in a socially responsible manner. By combining regional strengths with group network, HSBC’s aim is to be the leading bank in its target markets. HSBC’s goal is to achieve sustained earnings growth and continue to enhance shareholders value.

  Basic Drives

HSBC’s basic drives are Higher Productivity, Team Orientation, and Creative Organization & Customer Orientation.

The essence of HSBC brand is integrity, trust and excellent customer service. It gives confidence to customers, value to investors & comfort to colleagues.

Through the process of listening to individuals needs and then acting in partnership to deliver the right solutions, HSBC’s is committed to helping the clients make the most of their financial assets.

HSBC operate on a global basis, but also work on a local level to ensure the cross-border differences are identified and any related benefits exploited. HSBC teams of specialists ensure that whether you need solutions across the world, regionally or locally, they have the skills, expertise and resources to deliver them. They automate as many functions as possible, whilst ensuring you retain control.

HSBC claims that they are the people to talk to if anyone wants the following: –

  • Global cash flow co-ordination
  • Enhanced risk management
  • Improved security and audit controls
  • Minimized costs and reduced operating expenses
  • Maximized liquidity, returns and interest benefits

Group Business Principles and Value

The HSBC Group is committed to Five Core Business Principles:

  • Outstanding customer service;
  • Effective and efficient operations;
  • Strong capital and liquidity;
  • Conservative lending policy;
  • Strict expense discipline;

HSBC Operates According to Certain Key Business Values:

  • The highest personal standards of integrity at all levels;
  • Commitment to truth and fair dealing;
  • Hand-on management at all levels;
  • Openly esteemed commitment to quality and competence;
  • A minimum of bureaucracy;
  • Fast decisions and implementation;
  • Putting the Group’s interests ahead of the individual’s;
  • The appropriate delegation of authority with accountability;
  • Fair and objective employer;
  • A merit approach to recruitment/selection/promotion;
  • A commitment to complying with the spirit and letter of all laws and regulations wherever we conduct our business;
  • The promotion of good environmental practice and sustainable development and commitment to the welfare and development of each local community

HSBC’s reputation is founded on adherence to these principles and values. All actions taken by a member of HSBC or staff member on behalf of a Group company should conform to them.

In the following two sections a brief outline of the HSBC group’s financial profile and customer segment is provided.

Financial Profile of the Group


Customer Segments of HSBC Group


Overview Of HSBC Bangladesh

 HSBC Bangladesh

The HSBC Asia Pacific group represents HSBC in Bangladesh. HSBC opened its first branch in Dhaka in 17th December, 1996 to provide personal banking services, trade and corporate services, and custody services. The Bank was awarded ISO9002 accreditation for its personal and business banking services, which cover trade services, securities and safe custody, corporate banking, Hexagon and all personal banking. This ISO9002 designation is the first of its kind for a bank in Bangladesh. The HongKong and Shanghai Banking Corporation Bangladesh Ltd. primarily limited its operations to help garments industry and to commercial banking. Later, it extended its services to pharmaceuticals, jute and consumer products. Other services include cash management, treasury, securities, and custodial service.

Realizing the huge potential and growth in personal banking industry in Bangladesh, HSBC extended its operation to the personal banking sector in Bangladesh and within a very short span of time it was able to build up a huge client base. Extending its operation further, HSBC opened a branch at Chittagong, three branch offices at Dhaka (Gulshan, Mothijheel and Dhanmondi) and an offshore banking unit on November 1998.

HSBC Bangladesh is under strict supervision of HSBC Asia Pacific Group, Hong Kong. The Chief Executive Officer of HSBC Bangladesh manages the whole banking operation of HSBC in Bangladesh. Under the CEO there are heads of departments who manage specific banking functions e.g. personal banking, corporate banking, etc.

Currently HSBC Bangladesh is providing a wide range of services both two individual and corporate level customers. In the year 2000, the bank launched a wide array of personal banking products designed for all kinds of (middle and higher-middle income) individual customers. Some such products were Personal loans, car loans, etc. Recently the bank launched three of its personal banking products – Tax loan, Personal secured loan & Automated Tele Banking (ATB) service. These products are designed to meet the diverse customer needs more completely.

HSBC in Bangladesh also specializes in self-service banking through providing 24-hour ATM services. Recently it has introduced Day & Night banking by installing Easy-pay machines in Banani, Uttara and Dhanmondi to better satisfy the needs of both customers and non-customers. In total HSBC currently has 10 ATMs and 3 Easy-pay machines located at various geographical areas of Dhaka & Chittagong.

Over the years, HSBC has dynamically expanded its operations in Bangladesh both in terms of customer base and business volume. At present it is one of the fastest growing and most profitable banks in Bangladesh.

Name of the OrganizationThe Hong Kong Shanghai Banking Corporation Bangladesh Ltd.
Year of Establishment1996
Head OfficeAnchorTower, 1/1-B Sonargaon Road Dhaka 1205, Bangladesh
Nature of the organizationMultinational company with subsidiary group in Bangladesh
ShareholdersHSBC group shareholders
ProductsSavings & deposit services

Loan products

Corporate and Institutional services

Trade services


ManagementMr. Steve Banner, Chief Executive Officer

Mr. Mamoon Mahmood Shah, Head of Personal Financial Services

Mr. Mahbub-Ur-Rahman, Head of Corporate Banking

Mr. Syed Akhtar Hossain Uddin, Human Resource Manager

Mr. Munir Hussain, Marketing Manager

Mr. Wasim Adnan Wahed, Chief Operating Officer

Number of Offices8
Number of ATM’s        10
Number of employeesApproximately over 600

HSBC in Bangladesh also has an Offshore Banking Unit, which provides banking services for foreign companies based in the Export Processing Zones in Dhaka and Chittagong.

 Different Activities in Bangladesh

As one of the largest international banks in Bangladesh, HSBC has a long-term commitment to its customers and provides a comprehensive range of financial services: personal, commercial and corporate banking; trade services; cash management; treasury; consumer & business finance; and securities and custody services.

Personal Banking Services

HSBC offers a full range of personal banking products and services designed to take care of its customers’ growing needs and requirements. HSBC in Bangladesh has launched a number of loan products during 2000. Personal Installment Loan is an unsecured loan that does not require any personal guarantee or cash security; Car Loan, also, does not require any down payment or personal guarantee. The Bank has already launched Phone banking, a state-of-the-art automated telephone banking service available 24 hours a day, 7 days a week, and 365 days a year, which allows customers to access their account from the comfort of the office or home. HSBC is the market leader in the local Auto-Pay service with which the company can initiate bulk Taka payments to, or Taka collections from, any HSBC current or savings accounts of counterparts for a specified sum at a specified date, regardless of the branch. HSBC also offers Power-Vantage, a unique all-in-one package of products and services designed to give total financial control to the customer; a unique savings account, which allows the customer to do any number of transactions without any charges being incurred or credit interest lost. To satisfy the growing needs of real estate HSBC Bangladesh recently launched Home Loan Scheme and a special type of deposit product named “Bangladesh International” for non-resident Bangladeshi. Details of these products and more will be discussed later.

 Corporate Banking Services

HSBC offers a wide range of cash financing, working capital, short and medium-term loans and guarantee facilities from its Head Office and Chittagong branch. The Offshore Banking Unit (OBU) provides US Dollar denominated working capital as well as short-term finance for capital imports to eligible businesses. Using high-speed communication links, HSBC connects customers to international payment systems.

 Trade Services

As the leading provider of trade finance and related services to importers and exporters in Asia, HSBC in Bangladesh operates a highly automated trade-processing network and offers an Electronic Data Interchange (EDI) capability through Hexagon. The Bank also uses SWIFT, an efficient and secure mechanism for bank-to-bank global communications used for all trade related activities including fund transfers and issuance of DC’s (Documentary Credit).

Financial Institutions

HSBC provides global trade services and cash management services to local banks. HSBC’s worldwide network strength, with over 9500 offices in 76 countries and territories, coupled with a world class reputation in Trade Finance (“Best Trade Documentation Bank” – Euro money) places HSBC in an ideal position to render unmatched correspondent banking services.

HSBC’s commanding presence in the USA (5th largest USD clearing bank globally), UK (largest GBP clearing bank globally), and the Euroland (largest Euro clearing bank in the UK) allows the Bank to also provide first class cash management solutions in 3 major global currencies; USD, GBP and Euro.

  Payments and Cash Management

HSBC was the pioneer in introducing electronic cash management solutions in Bangladesh, by introducing its state-of-the-art proprietary software, Hexagon, back in 1997. This was initially made available to corporate clients only but has since been expanded to include banks and retail clients.

With Hexagon, the Bank’s cash management system, corporate customers can access banking services from anywhere in the world to view account balances and statements, make transfers and international payments, and to open documentary credits, by using only a PC, a modem and a telephone line.

Organizational Structure of HSBC Bangladesh


The organizational structure of HSBC Bangladesh is designed according to the various service and functional departments. The Chief Executive Officer (CEO) heads the chief executive committee, which decides on all the strategic aspect of HSBC. The CEO supervises the heads of all the departments and he is the ultimate authority of HSBC Bangladesh. The HSBC Chief Executive Committee is formed with the heads of all the departments along with the CEO.  Its structure is shown in the following figure.


Figure :       Organogram – Chief Executive Committee

HSBC follows a 4 layer management structure in Bangladesh. These are Managers, Executives, Officers and Assistant Officers. The CEO is the top most authority. Managers are the departmental heads who are responsible for formulating the strategies and the overall activities of their departments. Executives are basically responsible for certain activities & organizational functions. e.g. Admin Executive. These two layers represent the management level of HSBC Bangladesh.

Officers are the typical mid-level employees and are responsible for managing the operational activities and operating level employees. The operating level employees of HSBC who are ranked as Assistant Officer fill the last layer of this hierarchy. They perform the day-to-day operational activities of HSBC. An organizational hierarchy chart is shown below:


Figure : Organizational Hierarchy

Functional Departments of HSBC

HSBC activities are performed through functional departmentalization.  So, the departments are separated according to the functions they perform. Within the major departments there are some other subsidiary departments that allow smooth operation of their own major departmental function.

Personal Banking / Personal Financial Services (PFS)

PFS is the most flourishing department of HSBC Bangladesh. This department basically deals with the management of products and services offered to the individual consumers. Within a span of only five years, HSBC PFS has grown tremendously and is still growing with its innovative products and service offerings. PFS Head Mr. Mamoon Mahmud Shah manages this department. PFS Head manages and supervises the Personal Banking activities of the branch network of HSBC Bangladesh. The branches and booths of HSBC basically deal with the personal banking activities and provide various accounts services to individual customers.

Operations of PFS

Manages daily operation

Plans and directs sales and marketing

Plans for service development

Top-level authority for customers’ dealings and transaction

Provides required service to the customers directly

Maintains documentation and report flow vary rapidly

Helps in planning in field level

Assists PFS Head in decision-making process

Assists PFS Head in different level of research

Assists PFS Head day-to-day work

Keeps track and inform PFS Head in present condition of the competition in the market

Branch Network

There are eight branches of HSBC. Only the Dhaka office (head office) branch & Chittagong branch deals with both corporate and personal banking. The other offices only deal with the personal banking activities. There functions are to provide various financial services to the consumers. These include customer services, sale of various PFS products, opening new accounts, providing cash, remittance and other teller services, etc. The branches are quite decentralized for better delivery of services to customer and have their own premises and facilities. These branches are headed by branch managers. Each branch is staffed with its own team of employees. A great deal of teamwork is seen within these branches. ATM’s are situated with each branch premises.


The ATM center ensures smooth operation of the ATM machines. The ATM center is responsible for regular replenishment of the off-site ATM’s and servicing of all the ATMs. Currently a total 16 ATMs are in operation. The ATM center also deals with issuance, termination and servicing of the ATM cards. On a whole, the ATM center is the department that is solely responsible for all the activities related to ATM and is the facilitating department that enables customers 24 hour banking support.


This department is under the same manager as the ATM center. They basically deal with all the buying and selling of government bonds and treasury bills as per customer instruction, i.e. BSP, PSP, TSP etc. This department keeps under its control the transactions regarding USDB, USDIB and WEDB.


ATB refers to Automated Tele Banking. This department deals with the back office servicing of the HSBC phone banking services provided to customers. This department is basically responsible for the activation of ATB, ATB pin generation, and ATB security management, ATB blocking and troubleshooting of all ATB problems. This department is fairly new and was constructed on January 2001. Currently this department is staffed with one executive and one officer.

PFS Credit Department

The personal banking credit department deals with the consumer credit schemes such as the Personal loan, Car loan, Travel Loan, Personal Secured loan, etc. which are tailored to meet the demand of individual customers. The manager of PFS credit who approves and administers all the activities heads this department. He is staffed with one loan approval officer, one loan processing officer, two assistant officers and one MIS clerk. The approval officer mainly rejects or approves the credit requests. After being checked by the approval officer, the credit requests go to the processing officer for further processing of the application. This department is a member of ALCO (Asset Liability Management Committee), which coordinates in preparation of lending analysis and data on concentration of risk and identifies possible lending risks. This department is also responsible for monitoring all necessary documents and securities related to loans.

Corporate Banking

This division if HSBC provides financial services to organizational (corporate) clients. HSBC is a worldwide leader in banking and financial services whose success is based on its relationships with its corporate clients. Whether it is locally or around the world, HSBC offers a comprehensive range of services that can be tailored to the individual needs of the company. The Head of this department is the Chief of Corporate Banking. He is also the Vice-CEO of HSBC Bangladesh. The chief of Corporate Banking manages the activities of corporate banking of HSBC Bangladesh. Two offices of HSBC Bangladesh offer corporate banking services to corporate clients. These are the Dhaka Head Office and Chittagong office. Corporate Banking of HSBC Bangladesh includes Corporate Institutional Banking (CIB), Trade Service (HTV), and Hexagon. These sub-divisions are discussed briefly in the following sections along with a structure chart of Corporate Banking division of HSBC Bangladesh.



Corporate Institutional Banking (CIB)

As their major customers operate internationally, HSBC services them internationally. Operating through the major centers and in close liaison with HSBC Investment Bank, Corporate and Institutional Banking provides the full range of the Group’s capabilities at local and global levels, with a particular focus on payments and cash management, trade and securities custody. HSBC also offers local financial institutions and banks access to wide range of financial services available on an international basis.  The services are tailored to suit the needs of the companies. CIB has two separate wings: Relationship management department and Hexagon. These are discussed below:

Relationship Management Department

The RM department consists of various relationship managers who are assigned to different corporate client to better satisfy their needs. These RM’s communicate with the clients and are solely responsible for the companies they deal in. Any information regarding a corporate client must be communicated through the respective RM assigned to that corporate client. A relationship manager may be assigned more than one company and this decision depends on the chief of Corporate Banking.

HSBC Trade Services

Trade service is known by various names in other banks, e.g. Trade Finance Foreign Exchange, Foreign Trade etc. However, the functions are the same. As the name suggests, this department is involved in facilitating trade, both international & within Bangladesh.  HSBC is the leading provider of trade finance and related services to importers and exporters in Asia. Trade is considered a core business of the group. The group’s presence in 81 countries of the world gives a good opportunity to control both ends of a trade transaction and keep the business within the Group. The various awards it has won from the leading publications of the world acknowledge HSBC’s excellence in trade.  The trade service department has two separate subsidiaries: Credit Administration & Foreign Exchange Division.

Payment and Cash Management (PCM)

PCM deals with the inter-bank payment. PCM strategies are designed to ensure efficiency, profitably and comprehensive support.

Marketing Department

The sixth major department of HSBC is the marketing department. The marketing department of HSBC play a vital role in fostering the continuos growth HSBC in Bangladesh. A manager is assigned to this department who looks after the overall marketing operation of HSBC in Bangladesh. This department is basically concerned about marketing the company’s products, services and building a strong corporate image. The marketing department of HSBC has three subdivisions: Direct Sales, Promotion & Marketing Administration. These are discussed below:

Direct Sales (DS)

An executive is assigned to this part of the marketing department. The Direct Sales division coordinate & manages the sales activities of all the Mobile sales officers (MSO) of HSBC Bangladesh. The MSO’s basically makes sales of the company various Personal Banking products such as, savings accounts, consumer loan, etc outside the banking premises. There are a total of more than 50 mobile sales officers (MSO) employed in the cities of Dhaka and Chittagong. A MSO’s are assigned to specific branches for making sales activities more smoothly. The DS executive sets sales strategies & targets for the Sales officers and manages the whole team of MSO’s in Bangladesh. The direct sales department also decides upon the commission and remuneration of the mobile sales officers as their salary structure is based on sales performances.  Thus this part of the marketing division is very important for the overall growth of the Personal Banking Division.


This part of the marketing department deals with all the promotional activities of HSBC Bangladesh. Prime responsibilities of this department are: Maintaining strong public relations with various media intermediaries, Advertising the companies products and services, building a strong corporate image of HSBC in Bangladesh.

Public Relations

The promotion department organizes various environmental and social activities in order to build a strong corporate image of HSBC in the minds of customers as well as in the media. Maintaining strong relationship with news media is another major duty of this department.


The promotion also coordinates all the advertising of HSBC products within Bangladesh. Some of the advertising tools that are frequently used by the company are as follows:

a)    Newspapers Advertising: Regular advertisements of various products and services of HSBC are given in some of the countries most renowned daily newspapers.

b)    Billboards: Huge colourful billboards with HSBC logo are found in various major areas of Dhaka and Chittagong. These billboards emphasize on the needs of customers and shows HSBC logo as solution to their needs.

c)     Road Side Signposts: Medium sized multi colour signposts focusing on various products of HSBC are found on the roadsides of various posh areas such as, Gulshan, Dhanmondi, Baridhara, Motijheel, etc.

d)    Mailers: various product updates and new product information are regularly sent to existing customers of HSBC.

e)    Brochures: Various colourful brochures featuring specific products of HSBC are being displayed and distributed to existing and potential customers via branch offices and Mobile sales officers.

Marketing Administration Department

This department formulates & executes various marketing strategies of HSBC Bangladesh. This department also administers various marketing research activities on the existing and potential customers of HSBC. Some such research activities are: mystery shopping, critical incident surveys, customer suggestion surveys, etc. The results of these surveys are integrated while formulating various marketing strategies. This department also deals with the billing and invoicing of various marketing & advertising costs of HSBC Bangladesh.


This department works under FCD. Their main job is to take decisions regarding purchase and sell of foreign Currency. The purpose of Treasury’s operations is to utilize the funds effectively and arrange funds at a lowest possible rate of interest, through maintaining effective relationship with other banks and following the Government rules and foreign exchange regulations.

Credit Administration

Credit Administration department basically deals with all the documentation, processing, administration and disbursement of the import-export services provided to corporate clients. This department is known to be the heart of HSBC trade services that administers and manages all the trade tools and facilities provided by HSBC Corporate Banking. Some important aspects of this department are LC advising, documentation, OD facilities, guarantees, etc.

Finance Department of HSBC Bangladesh

This is considered as the most powerful department of HSBC. It keeps tracks of each and every transaction made within HSBC Bangladesh. It is headed by Manager of FCD who ensures that all the transactions are made according to rules and regulation of HSBC group. Violation of such rules can bring serious consequences for the lawbreaker. FCD is responsible for the preparation of the Annual Operating Plan (AOP), monitoring treasury risk limits, profit exposure and maintaining strong liquidity. FCD is the key member of the Asset Liabilities Management Committee (ALCO), which deals with how efficiently the bank’s assets and liabilities are managed. FCD also deals with money market matters. FCD acts as a custodian of all vouchers. FCD as the name implies does all the banks monitoring of the banks internal compliance and all local regulatory requirements.

The functions of FCD are briefly discussed below.

Services Department of HSBC

This is an integral and vital part of the bank. The services department ensures smooth operation and functioning within and between all the departments of HSBC. It also provides continuous support to the core banking activities of HSBC. The Manager of Services heads this department who formulates and manages various critical issues of the services function of HSBC. He is followed by a group of executives who are the heads of various subsidiary divisions that operate within the services department. The services department is considered as the backbone of all other departments. The various subsidiary divisions within this department are Administration, IT, Internal Control (IC), Network Services Center (NSC), and HUB.  A briefing of the subsidiary divisions is presented below:


Like that of any other organizations, the Admin department of HSBC makes sure that the organizations moves on with all its departments and staffs operating according to all the rules and regulations of the company. It also prevents any bottlenecks within the work process and ensures smooth functioning. The admin department has two divisions – General Administration and Business Support Services.

The general admin division is pretty much similar to the admin departments of other companies that ensure discipline and regulatory concerns. The business support services provide supports to the departments during employee leaves and sudden terminations so that the department can function without problems.

Information Technology (IT)

This department gives the software and hardware supports to different departments of the bank. As HSBC is engaged in online banking, the role of IT is very crucial for the bank. This department is the most active department of HSBC where employees always stand by to solve any problems in the system. The managers and executives of IT division work continuously to develop the total IT system of HSBC so that it can be operated with ease, accuracy and speed.

Internal Control

HSBC has internal auditors who visit on regular basis and submit the report to the higher authority for audit purposes. This gives different departments the chance to know their mistakes and take necessary corrective actions. Again, the Bank annually administers a company wide audit program to evaluate the overall performance of the bank in Bangladesh.

HSBC Universal Banking (HUB)

The HSBC banking system is called HUB. HSBC does the online banking and it is HUB, which sets up the parameter for that. This HUB is linked with the HSBC group via satellite and each and every transaction made by HSBC within Bangladesh is being recorded at the HSBC Asia-pacific headquarters at Hong Kong via HUB. Thus the HUB is the most powerful and important equipment of HSBC Bangladesh that monitors and tracks any fraud and faults made with HSBC Bangladesh.

NetworkServicesCenter (NSC)

This department can be described as the ‘Power House’ of HSBC Bangladesh. NSC does the back office job for the bank. The main four jobs that are performed by NSC are Clearing, Scanning of signature cards, issuing checkbooks and sending & receiving Remittances. NSC looks after the clearing process of HSBC and makes necessary contact with the central bank for maintaining account flows. All the customer signatures are scanned in this department and are entered into the system. NSC also issues checkbook for new and old accounts based on requisition from various branches. ‘Remittance’ is a banking term, which means ‘Transfer of funds through banks’. When a bank remits on behalf of its customers, it is termed as outward remittance. On the other hand, when the bank receives the remittance on behalf of the bank, it is inward remittance. The following are the methods that NSC used to remit money for customers: Telegraphic Transfer (TT), Demand Draft (DD) & Cashier’s Order.

Human Resource Department

The Human Resource Manager heads this department. The major functions of this department are strategic planning and policy formulation for Compensation, Recruitment, Promotion, Training and developments, Personnel Services and Security. The HR department is very much concerned with the discipline that is set up by the HSBC group. HSBC group has got strict rules and regulations for each and every aspect of banking, even for non-banking purposes; i.e. The Dress Code. All these major personnel functions are integrated in the best possible way at HSBC, which results in its higher productivity. The Human resource officer monitors the employee staffing and administration activities. The Training officer supervises Training, development & rotation activities.

These are the major departments of HSBC Bangladesh. Except the branches all other departments are situated at HSBC Bangladesh head offices located at AnchorTower, Kawran Bazar. Most of HSBC’s operations and activities are operated centrally from the head office. But to deal with customers more completely, the branches are given considerable authority and they operate in a more decentralized manner but subject to verification of the respective departments.


 Introduction to Capital Adequacy and Basel Accords

Capital Adequacy

Capital adequacy (CA) is defined as the minimum level of capital, which is required to protect a bank from portfolio losses. The concept of CA is very important in the banking industry as capital acts as the safeguard against depositors’ funds. Banks run primarily on depositors’ funds – they have the authority to mobilize deposits and lend the same. As such, they expose public deposits to potential credit risks and must take appropriate measures to minimize these credit risks through proper risk management systems. Capital acts as the cushion against any unforeseen losses arising market risks (interest rate risk, exchange rate risk, market price risk etc), operational risks and credit risks.

Bank owners are required to put in adequate capital:

  • To act as a cushion between depositors’ funds and loans made by the bank
  • To absorb any unforeseen losses arising from credit and other risks
  • Otherwise, depositors’ funds will be depleted with every loss.

But capital is only a supplementary arrangement for risk management and not a substitute. Hence, risk management should not be neglected even if there is adequate excess capital. Poor risk management can wipe out the entire capital of a bank and lead to collapse of the bank.

However, debate on the quantum of minimum level of capital required seems to be never ending. Though different methods and approaches were adopted in different points in time, they were insufficient to capture new dimensions and magnitudes of risk emanated from the continuous innovations in the domestic and international business. Consequently the 1970s and 80s experienced many uncertainties and volatilities that caused serious banking problems. The prevailing approach that a bank’s capital should be linked to a fixed ratio of its time and demand liabilities went under strong criticism on the ground that bank’s major risk is derived from the riskiness of its assets. The Basel Committee, based on this idea, designed Capital Regulation in 1988, which is known as the Basel Accord I.

The Basel Committee on Banking Supervision is a committee of banking supervisory authorities that was established by the central bank governors of the Group of Ten countries in 1975. It consists of senior representatives of bank supervisory authorities and central banks from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom, and the United States. The name of the committee has been derived from the location of its permanent Secretariat at the Bank for International Settlements (BIS) in Basel, Switzerland.

Basel I accord requires banks to maintain a Regulatory Capital (RC) of not less than 8% (9% in Bangladesh), in relation to their total credit risk, measured on the basis of aggregated risk weighted value of their:

  • On balance sheet exposure (all assets other than riskfree assets, such as cash, Treasury bills etc)
  • Off balance sheet exposure (commitments & contingencies such as LCs)

In 1996, the RC requirement was extended to cover market risk as well.

Hence, Basel I can be summarized as follows:

[(Tier I + Tier II) – deductions]

Regulatory Capital Adequacy Ratio (RCAR) = ——————————————- X 100 >=9%

[Credit Risk (= Risk weighted assets

+ Contingencies) + Market risk]

Shortfall in RCAR is not permitted under this accord. However, excess in RCAR is always encouraged as it has many advantages as follows:

  • Having the minimum 9% capital adequacy (CA) means that the bank can take a hit upto 9% of its RC without endangering depositors’ funds.
  • Any excess over 9% CA enhances the bank’s loss sustaining capacity
  • It also indicates the size of the capital buffer available for future growth
  • Regarded as symbol of financial stability
  • Facilitates higher credit ratings for banks (CA is the 1st pillar in CAMEL rating)

Thus the Basel I accord established a direct relationship between the total risk profile and the RC of the bank Hence risk assets expansion of a bank is required to be backed by adequate growth in RC. Not only the capital expenditure or overseas expansion projects, but the entire risk-asset creation process of banks, including their lending, has to be backed by capital. Therefore, ebem the normal organic growth of a bank has to be backed by RC.

If we look at the components of the RCAR, we see that the denominator, i.e. total risk profile of the bank increases with the growth in business volumes. Unless the numerator, i.e. RC too increases at the same pace, the RCAR falls. But this kind of growth is not possible, unless the bank has excess RC. Even in situations where the bank has excess RC, this kind of growth would reduce the RCAR.

Banks are compelled to curtail their risk asset growth in instances where:

  • There is not enough excess RC or
  • They are unable to raise the required capital

Even if

  • Funds have been raised through low cost deposits
  • There is a demand for good quality advances.

Sources of raising RC:

One source of raising RC is through retained profits. However, retained profit alone is not sufficient as fund based operation simply cannot produce the required rate of return (say 9%) as

  • Rate of interest on advances are market determined
  • Cost of funds and overhead expenses are to be incurred.
  • High amount of tax and VAT has to be paid.
  • Fair dividends also has to be set aside.

Hence no advance can produce a return of 9% after tax and dividends. The following calculation illustrates the mechanism.


Return on an advance of BDT 100 granted @ 15% p.a.                 15.00

Less: Average funding cost after the SLR (est)                                7.90

Net Interest Income                                                                     7.10

Less: Operational expense (Based on bank’s cost/income ratio)       3.76

Net Income                                                                                 3.34

Less: Corporate tax @ 40%                                                          1.34

Post-tax return on the advance                                                      2.00

Thus, the advance granted @ 15% p.a. generated return of only 2.00% after all taxes. After dividends, the ultimate return may be around 1.20%. Hence a capital shortfall arises as follows:

Required return on advances                                                       9.00%

Possible return on advances                                                        1.20%

Capital shortfall                                                                          7.80%

This shortfall has to be funded from other sources. The return on other low yielding assets may be even lower. In the case of NPLs, there is no return at all and hence banks are compelled to provide for the NPL to the extent necessary and to provide the entire 9% capital from external sources for the loan amount not covered by provisions.

Another source of raising RC is through issuance of ordinary shares, but shareholders will naturally ask for a fair return of around 15-16% p.a., inclusive of a risk premium over bank deposit rates due to the market risk involved. To generate a ROE of 15-16% on the RC, the ultimate return on advance (after tax and after dividends) should at least be 1.2% p.a.

If a good rate of return of around 1.2% is maintained on advances, a bank could produce a ROE very close to this expected level, even if the full capital shortfall of 7.80% is raised through Tier I.

1.2 X 100

ROE = ————- = 15.38%


Properly run banks can produce this return, provided the loan remains performing. The return could however be further improved if part of the RC shortfall can be raised from Tier II. Hence Tier II instruments are also important.

Tier II instruments, the other source of RC, mainly includes corporate debts. These debts are usually priced 2.0% to 4.0% over the T bills rates. However, allowable quantum of Tier II instruments is capped at 50% of Tier I under Basel II accord. There are also various market limitations in raising capital under corporate debts. In addition, annual discounting has to be done on outstanding corporate debt.

The Basel I Accord:

Two fundamental objectives of the Accord were (a) to strengthen the soundness and stability of the international banking system and (b) to obtain a high degree of consistency in its application to banks in different countries with a view to diminishing an existing source of competitive inequality among international banks. To that end, the accord requires that banks meet a minimum capital ratio that must be equal to at least 8 percent of total risk-weighted assets.

If judged by the extent to which it has been taken up around the world, the 1988 Basel Capital Accord (“Basel I”) was a great success: it has been implemented as the capital adequacy standard for banks by more than 100 countries. A relatively simple measure of capital adequacy, Basel I has been adopted not only by the leading industrialized nations, but also by middle income and developing countries, including most in Asia.

The original accord was intended to apply to internationally active banks with the aim of shoring up bank capital levels globally while also promoting a more “level playing field” so that weakly capitalized institutions from one country would not have a competitive advantage over its better capitalized competitors that needed to charge higher interest rates to achieve an adequate return on capital.

Weaknesses in Basel I Accord

Despite its many merits, the Accord has been widely criticized for its failure to achieve the stated objectives. Since it introduced risk-based capital requirement, which was adopted by many developed and developing countries as well, it was expected that the Accord would help to strengthen financial system stability and reduce banking and financial crises. On the contrary, banking crises again occurred in 1990s even in some robust economies of East Asia.

Basel I has been effective in raising capital levels globally. It was clear from the beginning, however, that the accord had weaknesses, mostly with respect to its crude measurement of a bank’s credit risk exposure. There was no customer wise assessment of risk. In stead, all exposures were classified into a few broad risk brackets based on either “due from whom” or “collateral held” and a standard set of risk weights applied on groups as follows:

Table : Risk Weights used under Basel I Accord


Hence, most advances were risk graded at a flat rate of 100%, irrespective of their credit worthiness and totally disregarding whether they are:

  • Corporate or small industry
  • Short-term or long-term
  • High risk or low risk
  • AAA rated or hard-core/non-performing

The 8% charge (or 100% risk-weight) applied to almost all corporate credits is an excessively broad brush approach. This provided very little incentives for the banks to improve risk management. As all advances were subject to same capital charge, cost of capital became flat for all loans (irrespective of risk) and there were no capital incentives for good quality lending. Over time, this treatment has generated some perverse incentives, notably for banks to sell off high quality assets and retain exposures to higher risk, lower quality borrowers, since both are subject to the same 8% charge. This could even lead to under-pricing of risky loans and denial of price advantage to good quality borrowers.

Rodriguez (2002) and others argue that the use of arbitrary risk categories and arbitrary weights that bear no relation to default rates incorrectly assume that all assets within one category are equally risky. The risk assessment methodology is flawed in the sense that it assumes a portfolio’s total risk is equal to the sum of the risks of the individual assets in the portfolio. No account is taken of portfolio management strategies, which can greatly reduce the overall risk of a portfolio, or of the size of a portfolio, which can greatly influence its total risk profile. Collaterals other than cash, government guarantees and government debt was not given any consideration also.

The accord gives preferential treatment to government securities, which are considered risk-free. The sovereign debt defaults of Russia in the summer of 1998 and Argentina in early 2002 demonstrated that government debt is not a risk free investment. Other criticisms include that the accord sets capital standards only for credit risk (i.e., the risk of counterparty failure), but not for other types of risk such as operational risk and market risk. Consequently, capital requirement was not reflective of economic risk. It has not provided enough incentive for risk management, risk mitigation and innovation in risk management such as arbitrage opportunities through securitization.

The use of securitization posed a particular problem for regulators, as it provided a mechanism for banks to “arbitrage” their regulatory ratios. By securitizing high quality assets and keeping the subordinated tranche of their issues (e.g. 20% of the amount securitized) the banks were in effect retaining the bulk of the credit risk, yet this risk was not being fully reflected in their Basel I ratios. Another example is the Basel I use of membership in the Organization for Economic Cooperation and Development (OECD) as a basis for determining a country’s creditworthiness, with OECD bank and sovereign lending benefiting from lower capital charges. An anomaly became increasingly apparent as banks from certain OECD members, such as Mexico, Turkey and Korea, attracted lower charges than banks from better-rated and hence lower-risk non-OECD countries such as Hong Kong and Singapore.

When the Accord was formalized, no consensus and consultation were taken from the representatives of the developing nations. Therefore, it is sometimes criticized as OECD Club-rule. McDonough (2000) argues that as banks have developed innovative techniques for managing and mitigating risk, credit risk now exists in more complicated, less conventional forms than is recognized by the 1988 Accord, thus rendering capital ratios, as presently calculated, less useful to banking supervisors. The financial world has changed dramatically over the past dozen years, to the point that the Accord efficacy has eroded considerably (McDonough, 2000).

 Development of Basel II Accord:

The Basel Committee on Banking Supervision has been working over recent years to secure international convergence on revisions to supervisory regulations governing the capital adequacy of internationally active banks in order to rectify the weaknesses of Basel I accord. Following the publication of the Committee’s first round of proposals for revising the capital adequacy framework in June 1999, an extensive consultative process was set in motion in all member countries and the proposals were also circulated to supervisory authorities worldwide. The Committee subsequently released additional proposals for consultation in January 2001 and April 2003 and furthermore conducted three quantitative impact studies related to its proposals. As a result of these efforts, many valuable improvements have been made to the original proposals. The final Basel II accord presents the consensus agreed by all its members. It sets out the details of the agreed Framework for measuring capital adequacy and the minimum standard to be achieved which the national supervisory authorities represented on the Committee will propose for adoption in their respective countries. This Framework and the standard it contains have been endorsed by the Central Bank Governors and Heads of Banking Supervision of the Group of Ten countries.

The primary objective of the new Accord is to make it more risk-sensitive so that financial institutions will be able to sustain even in periods of financial crisis. Consequently, the new proposal moves ahead of the “one-size-fit-all” approach. Another objective of the Accord is to continue to enhance competitive equality among the internationally active banks throughout the world.

The Committee believes that the revised Framework will promote the adoption of stronger risk management practices by the banking industry, and views this as one of its major benefits. The Committee notes that, in their comments on the proposals, banks and other interested parties have welcomed the concept and rationale of the three pillars (minimum capital requirements, supervisory review, and market discipline) approach on which the revised Framework is based. More generally, they have expressed support for improving capital regulation to take into account changes in banking and risk management practices while at the same time preserving the benefits of a framework that can be applied as uniformly as possible at the national level.

In developing the revised Framework, the Committee has sought to arrive at significantly more risk-sensitive capital requirements that are conceptually sound and at the same time pay due regard to particular features of the present supervisory and accounting systems in individual member countries. The Committee is also retaining key elements of the 1988 capital adequacy framework, including the general requirement for banks to hold total capital equivalent to at least 8% of their risk-weighted assets; the basic structure of the 1996 Market Risk Amendment regarding the treatment of market risk; and the definition of eligible capital.

A significant innovation of the revised Framework is the greater use of assessments of risk provided by banks’ internal systems as inputs to capital calculations. In taking this step, the Committee has also put forward a detailed set of minimum requirements designed to ensure the integrity of these internal risk assessments. Each supervisor will develop a set of review procedures for ensuring that banks’ systems and controls are adequate to serve as the basis for the capital calculations. Supervisors will need to exercise sound judgments when determining a bank’s state of readiness, particularly during the implementation process.

The revised Framework provides a range of options for determining the capital requirements for credit risk and operational risk to allow banks and supervisors to select approaches that are most appropriate for their operations and their financial market infrastructure. In addition, the Framework also allows for a limited degree of national discretion in the way in which each of these options may be applied, to adapt the standards to different conditions of national markets. These features, however, will necessitate substantial efforts by national authorities to ensure sufficient consistency in application. The Committee intends to monitor and review the application of the Framework in the period ahead with a view to achieving even greater consistency. In particular, its Accord Implementation Group (AIG) was established to promote consistency in the Framework’s application by encouraging supervisors to exchange information on implementation approaches.

It should be stressed that the revised Framework is designed to establish minimum levels of capital for internationally active banks. As under the 1988 Accord, national authorities will be free to adopt arrangements that set higher levels of minimum capital. Moreover, they are free to put in place supplementary measures of capital adequacy for the banking organizations they charter. National authorities may use a supplementary capital measure as a way to address, for example, the potential uncertainties in the accuracy of the measure of risk exposures inherent in any capital rule or to constrain the extent to which an organization may fund itself with debt. Where a jurisdiction employs a supplementary capital measure (such as a leverage ratio or a large exposure limit) in conjunction with the measure set forth in this Framework, in some instances the capital required under the supplementary measure may be more binding. More generally, under the second pillar, supervisors should expect banks to operate above minimum regulatory capital levels.

Under the Basel II accord, banks and supervisors are to give appropriate attention to the second (supervisory review) and third (market discipline) pillars of the revised Framework. It is critical that the minimum capital requirements of the first pillar be accompanied by a robust implementation of the second, including efforts by banks to assess their capital adequacy and by supervisors to review such assessments. In addition, the disclosures provided under the third pillar of this Framework will be essential in ensuring that market discipline is an effective complement to the other two pillars.

The Committee is aware that interactions between regulatory and accounting approaches at both the national and international level can have significant consequences for the comparability of the resulting measures of capital adequacy and for the costs associated with the implementation of these approaches. The Committee believes that its decisions with respect to unexpected and expected losses represent a major step forward in this regard.

The Committee has designed the revised Framework to be a more forward-looking approach to capital adequacy supervision, one that has the capacity to evolve with time. This evolution is necessary to ensure that the Framework keeps pace with market developments and advances in risk management practices, and the Committee intends to monitor these developments and to make revisions when necessary. In this regard, the Committee has benefited greatly from its frequent interactions with industry participants and looks forward to enhanced opportunities for dialogue. The Committee also intends to keep the industry appraised of its future work agenda.

 Conceptual Framework of the New Accord

The New Accord has defined a structured framework comprising three pillars such as Pillar I, II and III. Pillar I sets out minimum capital requirements. Pillar II defines the process of supervisory review of a financial institution’s risk management framework. Pillar III determines market discipline through improved disclosure.

Pillar I ‐ Minimum Capital Requirement  

In Pillar I, three kinds of risk such as credit risk, market risk and operational risk are considered to determine the minimum capital requirement. The definition of eligible regulatory capital remains the same as outlined in the 1988 Accord i.e., the ratio of capital to risk-weighted asset remains unchanged at 8%. However, the credit risk assessment process has been completely revised.  




Figure : Structure of the Pillar I Under Basel II Accord

Banks are given a choice of options to measure each risk, subject to

  • Extent of their preparedness to adopt such an approach and
  • With the concurrence of the regulator

Pillar II ‐ Supervisory Review  

Pillar II ensures that not only do banks have adequate capital to cover their risks, but also that they employ better risk management practices so as to minimize the risks. Supervisors will be expected to evaluate the board and management of banks, to look into strategic decisions and to evaluate portfolio diversification as well as the ability to react to future risks in a rapidly changing environment. In particular, issues of transparency, corporate governance and efficient markets can be considered as additional challenges in pillar II enforcement.

Pillar III ‐ Market Discipline  

Banking operations are becoming complex and difficult for supervisors to monitor and control. In this context, Basel Committee has recognized the importance of market discipline and has suggested to implement it by asking banks to make adequate disclosures. The potential audiences of these disclosures are supervisors, bank’s customers, rating agencies, depositors and investors. With frequent and material disclosures, outsiders can learn about the bank’s risks.

Scope of Application

This Framework will be applied on a consolidated basis to internationally active banks. This is the best means to preserve the integrity of capital in banks with subsidiaries by eliminating double gearing.

The scope of application of the Framework will include, on a fully consolidated basis, any holding company that is the parent entity within a banking group to ensure that it captures the risk of the whole banking group. Banking groups are groups that engage predominantly in banking activities and, in some countries, a banking group may be registered as a bank.

The Framework will also apply to all internationally active banks at every tier within a banking group, also on a fully consolidated basis (see illustrative chart at the end of this section). A three-year transitional period for applying full sub-consolidation will be provided for those countries where this is not currently a requirement.

Further, as one of the principal objectives of supervision is the protection of depositors, it is essential to ensure that capital recognized in capital adequacy measures is readily available for those depositors. Accordingly, supervisors should test that individual banks are adequately capitalized on a stand-alone basis.

Banking, securities and other financial subsidiaries

To the greatest extent possible, all banking and other relevant financial activities (both regulated and unregulated) conducted within a group containing an internationally active bank will be captured through consolidation. Thus, majority-owned or –controlled banking entities, securities entities (where subject to broadly similar regulation or where securities activities are deemed banking activities) and other financial entities should generally be fully consolidated.

There may be instances where it is not feasible or desirable to consolidate certain securities or other regulated financial entities. This would be only in cases where such holdings are acquired through debt previously contracted and held on a temporary basis, are subject to different regulation, or where non-consolidation for regulatory capital purposes is otherwise required by law. In such cases, it is imperative for the bank supervisor to obtain sufficient information from supervisors responsible for such entities.

If any majority-owned securities and other financial subsidiaries are not consolidated for capital purposes, all equity and other regulatory capital investments in those entities attributable to the group will be deducted, and the assets and liabilities, as well as third-party capital investments in the subsidiary will be removed from the bank’s balance sheet. Supervisors will ensure that the entity that is not consolidated and for which the capital investment is deducted meets regulatory capital requirements. Supervisors will monitor actions taken by the subsidiary to correct any capital shortfall and, if it is not corrected in a timely manner, the shortfall will also be deducted from the parent bank’s capital.

Significant minority investments in banking, securities and other Financial entities

Significant minority investments in banking, securities and other financial entities, where control does not exist, will be excluded from the banking group’s capital by deduction of the equity and other regulatory investments. Alternatively, such investments might be, under certain conditions, consolidated on a pro rata basis. For example, pro rata consolidation may be appropriate for joint ventures or where the supervisor is satisfied that the parent is legally or de facto expected to support the entity on a proportionate basis only and the other significant shareholders have the means and the willingness to proportionately support it. The threshold above which minority investments will be deemed significant and be thus either deducted or consolidated on a pro-rata basis is to be determined by national accounting and/or regulatory practices. As an example, the threshold for pro-rata inclusion in the European Union is defined as equity interests of between 20% and 50%.

The Committee reaffirms the view set out in the 1988 Accord that reciprocal crossholdings of bank capital artificially designed to inflate the capital position of banks will be deducted for capital adequacy purposes.

Insurance entities

A bank that owns an insurance subsidiary bears the full entrepreneurial risks of the subsidiary and should recognize on a group-wide basis the risks included in the whole group. When measuring regulatory capital for banks, the Committee believes that at this stage it is, in principle, appropriate to deduct banks’ equity and other regulatory capital investments in insurance subsidiaries and also significant minority investments in insurance entities. Under this approach the bank would remove from its balance sheet assets and liabilities, as well as third party capital investments in an insurance subsidiary. Alternative approaches that can be applied should, in any case, include a group-wide perspective for determining capital adequacy and avoid double counting of capital.

Banks should disclose the national regulatory approach used with respect to insurance entities in determining their reported capital positions.

Significant investments in commercial entities

Significant minority and majority investments in commercial entities which exceed certain materiality levels will be deducted from banks’ capital. Materiality levels will be determined by national accounting and/or regulatory practices. Materiality levels of 15% of the bank’s capital for individual significant investments in commercial entities and 60% of the bank’s capital for the aggregate of such investments, or stricter levels, will be applied. The amount to be deducted will be that portion of the investment that exceeds the materiality level.

Investments in significant minority- and majority-owned and -controlled commercial entities below the materiality levels noted above will be risk-weighted at no lower than 100% for banks using the Standardized approach. For banks using the IRB approach, the investment would be risk weighted in accordance with the methodology the Committee is developing for equities and would not be less than 100%.

Deduction of investments pursuant to this part

Where deductions of investments are made pursuant to this part on scope of application, the deductions will be 50% from Tier 1 and 50% from Tier 2 capital.

Goodwill relating to entities subject to a deduction approach pursuant to this part should be deducted from Tier 1 in the same manner as goodwill relating to consolidated subsidiaries, and the remainder of the investments should be deducted as provided for in this part. A similar treatment of goodwill should be applied, if using an alternative group-wide approach pursuant to paragraph 30.

The limits on Tier 2 and Tier 3 capital and on innovative Tier 1 instruments will be based on the amount of Tier 1 capital after deduction of goodwill but before the deductions of investments pursuant to this part on scope of application.

DJDefinition of terms used

The following pages provide an understanding of the inputs to the calculation of some of the items used in various risk measurement approaches under Basel II.

Probability of Default (PD)

It is based upon a specific definition of default. A corporate default is considered to have occurred with regard to a particular obligor when either or both of the following events have taken place:

• The bank considers that the obligor is unlikely to pay its credit obligations to the Group in full or on originally agreed repayment terms, without recourse by the bank to actions such as realising security (if held).

• The obligor is past due more than 90 days on any material credit obligation to the Group. [In the case of revolving facilities and instalment loans, this means 90 days past repayment date. In the case of overdrafts, it means 90 consecutive days over agreed limit.].

The probability of a borrower defaulting is represented in a Customer Risk Rating (CRR) scale.

 Customer Risk Rating

Customer Risk Rating is an obligor PROBABILITY OF DEFAULT (PD) risk profile scale that does NOT take into any account the type of facility, or collateral or realizable value of the collateral i.e. it ignores LGD% and EaD.

This shows the % probability of default within a one-year time horizon (ranging from 0.00% (for select OECD sovereigns only) to 75% for a very high-risk customer) taking into account both quantitative and qualitative information. For ease of understanding the default %s are grouped into buckets. Each bucket is matched to a narrative description. Each successive bucket contains a wider range of % because the scale is a logarithmic scale (i.e. the PD risk curve of the borrower is non-linear and becomes steeper the closer the borrower nears default).

Probability of Default (PD)% scale

The 22 point CRR scale is the Advanced logarithmic scale applicable to both Bank and Corporate (including NBFI). Although each CRR covers a range of %s it is calibrated to the mid-point of each grade. It is the mid point % that is used to calculate a RWA%

This estimated PD % is automatically assigned by the credit systems (CARM). The disadvantage to using the standard scale is that the greatest PD % is applied for each default risk. The consequence is the inability to take advantage of the granularity of the advanced scale

The following table shows a mapping between CRR, its narrative description and the PD % and a comparison of the CRR with external ratings provided by S&P and Moodys. (S&P is a PD rating approach consistent with the HSBC approach. Moodys is an EL approach).


Facility Grade

Facility Grade (FG) is an EXPECTED LOSS (EL) risk profile scale. FG is in summary a judgmental grading EL methodology that combines the effects of the PD, LGD and EaD. This provides a guide as to the risk profile of a customer (specifically focusing on the ability to repay) after taking into all aspects of the risk. This includes the likelihood of the obligor defaulting, the value of and the ability to realize collateral, and other mitigating circumstances.

 Loss Given Default (LGD): IRB – Advanced Approach

LGD is the estimate of the % of the exposure that will be lost in the event of default. This % is calculated at the time a facility is approved. It remains constant until the next time a facility limit or collateral is changed. The conservative view is that a facility limit will be fully utilized. Therefore it is the limit that is used as a proxy for EaD in the calculation of LGD%

The approach for Corporate (including NBFIs) recognize there are three important drivers to derive the value of a recovery value.

Regions: Certain legal jurisdictions make it very unfavorable for a creditor in a recovery situation. This typically means that a creditor will on average receive less cash and over a longer time period, which in net-present-value terms means a lower recovery rate. This can affect both collateral recovery rates and claims made by an unsecured creditor.

Collateral amount and type: The framework will take into account recoveries from different types of collateral (e.g. commercial real estate, marketable securities or bank guarantees). It explicitly includes the fact that the recovered amounts for collateral can vary, i.e. even if a loan is fully secured there is a chance that HSBC will not recover the full outstanding amount.

Borrower segment and seniority: Even if two different loans are secured by the same amounts and types of collateral and are from the same region, the LGD can show significant differences attributable to the segment (Corporate, NBFI, Bank etc) and seniority (Senior or Junior).

The calculation of the LGD% is complex process that summarized as follows:

• The limit is split into two parts. a) That secured by Zero Volatility Collateral (e.g. Cash) based upon the value of the security and its recovery rate and b) the balance referred to as Net Limit (or that secured by Volatile collateral).

• At the discretion of an entity, a floor LGD% will be applied to the Zero-Volatility limit.

• A Black-Scholes model is needed to calculate the LGD% for the Net Limit since it contains three variables a) recovery rate, b) volatility of collateral c) unsecured LGD%.

• The LGD% for the overall facility will be the weighted-average of the LGD % calculated for the two parts of the limit.

• The overall LGD% is then adjusted to include an Administrative Cost add-on %.

 Exposure at Default (EaD) calculation: IRB – Advanced Approach

EaD is an estimate of exposure (both on and off-balance sheet) to a counterpart in the event of default. This is achieved by predicting the borrowing behavior of the counterpart over the next year should the counterpart default on its obligations. Hence, the methodology translates the current exposure for a healthy counterpart to actual estimated exposure at the time of that counterpart’s default. The EaD for a current exposure and unutilized limit will vary dependent upon the country in which the facility is booked principally due to experience of draw-downs of unutilized overdraft / revolving facilities. The calculation of the EaD depends on a specific facility and its characteristics that are grouped into three broad categories:

Fixed principal products. For these products the schedule of payments is known (e.g. term loans). The EaD therefore equals the forecasted outstanding (one- year from now) including potentially unpaid accrued interest subject to the proviso that EaD cannot be lower than current outstanding. For un-drawn approved limits EaD is equal to the limit.

Global markets products. For these products the current methodology is based upon credit conversion factors. However, proposals have recently been distributed that are likely to permit a number of approaches including an Expected Positive Exposure (EPE) approach i.e. a model-based approach.

Variable exposure product. The characteristics of variable exposure are defined within the following sub-categories:

• Revolving facilities, overdrafts and Trade Finance. The EaD needs to take into account unutilized exposures (referred to as Available Headroom). The % of this Available Headroom is added to the current exposure to calculate the EaD.

• Guarantees. Although a standard 20% of outstanding has been proposed to calculate the EaD in due course % it is likely that this % will vary by type of guarantee.

• For liquidity facilities a standard 90% of the commitment has been proposed for the EaD.

• Payment and settlement products.


The Effective Maturity of a facility is the longest possible time before the counterpart is scheduled to fulfill its obligation, taking into account any applicable grace period. Effective Maturity is a concept that applies to both funded on-balance sheet facilities and contingent liabilities e.g. liquidity facilities.

  Economic Capital

Economic capital (EC) is a measure of risk, not capital held. Whereas most traditional measures of capital adequacy relate existing capital levels to assets, EC relates capital to risks. It is therefore a more forward-looking measure of capital adequacy and a common currency of risk across all businesses. EC can be expressed as protection against unexpected future losses at a selected confidence level (say 99.95%). It is the level of capital needed to sustain the risk level of the institution over a given time horizon and at the appropriate level of safety that the institution offers its debt holders and depositors.

 Expected and Unexpected loss

Expected loss (EL) is the anticipated average loss over a defined time period. EL represents a cost of doing business that will be covered by operating income. It can be represented by the formula PD% * LGD% * EaD. Whereas, Unexpected loss (UL) is the potential for actual loss to exceed the EL, and is why capital reserves are required. The key risk categories that can result in UL are: Credit risk (losses due to counterpart defaults and / or credit downgrades), market risk, interest rate risk and operational risk. The other UL risk categories include reputation risk; overall business risk (from increased competition, product and technological obsolescence); pension fund risk (potential funding deficits); liquidity funding risk; and insurance risk (underwriting risk).

 Confidence level

The confidence level (CL) is the risk of default during a defined time period. One year has been chosen as it is believed to be the time over which mitigating action could be taken for impaired assets and new capital could be raised if needed. This is also consistent with the Basel 2 time horizon assumptions. A higher CL results in a lower the probability of default. To arrive at the appropriate CL it is usually linked to the standard of solvency implied by the credit rating of its senior debt using long term S&P default studies. The CL that equates with HSBC AA rating is 99.95%, indicating an ability to cover all but the worst 5 of every 10,000 possible risk scenarios within a 1-year time horizon.

When calculating the UL to the required confidence level, diversity of the global portfolio in terms of country and industry are taken into account. The consequence of calculating the Economic Capital on a consolidated basis for CIBM is that the value of the relationship with the customer can be expressed as Risk Adjusted Return on Capital. HSBC plans to have an Economic Capital model in place towards the end of 2006.

 Risk Weighted Asset % & Value Calculation

The calculation of a Risk Weighted Asset % (RWA%) requires five principal pieces of information for an obligor:

• Asset Classification, (Corporate, Bank etc)

• Basel Approach, (a) Standardized, b) Internal Ratings Based – Foundation, c) Internal Ratings Based – Advanced

• The % Probability of Default, (PD) for the obligor derived from a Customer Risk Rating (CRR).

• The estimate of the % of the exposure that will be lost in the event of default. This is called the Loss Given Default % (LGD)

• The Effective Maturity (M) of each facility.

The Risk Weighted Asset Value (RWAV) is equal to estimated Exposure at Default (EaD) for each facility multiplied by RWA %.

The calculation of the Capital Requirement value (CRV) is the same formula as Basel I. It is RWAV * appropriate capital adequacy% (in accordance with the local regulatory guidelines e.g. 8%). However, the inputs required for calculation of RWAV has changed and the regulators have also prescribed a multiplier (1.06) to calibrate overall regulatory capital ratios to align them with Basel I.

 Analysis of Credit Risk Approaches of Basel II

Reports and articles published in various financial magazines reveal that most bank supervisors across the globe will implement Basel II as a key part of their bank supervisory regime, and that in most countries the larger banks are generally aiming to go beyond the Standardized approach to use one of the Internal Ratings Based (IRB) approaches to credit risk. The IRB approaches are likely to be adopted in the more developed banking systems (Japan, Hong Kong, Singapore) starting around 2007 to 2008 and in others in subsequent years. While over time the adoption of the IRB approaches should lead to more sophisticated risk management practices, developing the risk rating systems and infrastructure needed to become an IRB bank could pose challenges for a number of Asian institutions, most of which are in the early stages of building up their loss databases, developing ratings models and improving the integrity of their risk management systems.

Implementing Basel II and supervising IRB banks will present challenges for bank supervisors as well, as more technical skills and resources will be needed. Countries that are planning to adopt Basel II have to think carefully about these resource needs and consider the benefits and costs of Basel II adoption within the broader context of their other supervisory priorities. For example, strengthening the fundamentals of their legal and regulatory infrastructure is likely a more immediate priority than – and indeed an important precursor to – moving to introduce Basel II. If their Basel II implementation efforts are to be credible, supervisors will need to move away from the past tendency (prevalent in many  countries) to use regulatory forbearance to support weak banks. In terms of the potential market impact of Basel II, the effects are likely to vary across banks depending on their choice of regulatory approach (i.e., Standardized, Foundation IRB, Advanced IRB) as well as the composition of their portfolios. As a general matter, weaker borrowers will attract higher charges under Basel II, which may raise their borrowing costs. Stronger borrowers are likely to benefit from lower capital charges under a Basel II capital regime Retail lending also becomes even more attractive under Basel II thanks to the generally lower charges assigned to residential mortgage and credit card lending, which may accelerate the existing shift of Asian banks toward retail banking.

An important consideration facing supervisors is how well suited the Basel II framework is to their market and whether the Basel II charges are sufficient to cover banks’ risk exposure. In cases where the supervisor believes that Basel II does not fully capture inherent risks in the domestic banking system, then it is appropriate for them to apply “super-equivalent” (i.e., more stringent) charges. For example, the recent problematic experience of some areas of retail lending, such as credit cards in Korea, might suggest that additional capital is needed to cover the risks of this market. As an additional example, under the Foundation IRB the assumed loss rate when a loan defaults (LGD) is 45% for unsecured corporate loans (i.e., a recovery rate of 55%); however, in reality, loss rates on unsecured lending in emerging Asia have been much higher than this level.

Bank supervisors will need to consider carefully whether the assumptions built in to Basel II are applicable to their banking systems. If in their view the charges do not fully capture the risks inherent in local markets, supervisors could either decide to apply more conservative assumptions within the capital calibration for specific assets (such as applying a higher risk-weight than Basel II), or set overall capital requirements at a higher level than 8%. More broadly, this highlights the need for national supervisors not simply to import the Basel Committee guidelines wholesale, but to adapt them to local realities.

Basel II is built on the so-called “Three Pillars” of capital adequacy, namely:

  • • Pillar 1: the Minimum Capital Requirement
  • • Pillar 2: Supervisory Oversight
  • • Pillar 3: Market Discipline, based on risk-based disclosure.

Most attention is focused on Pillar 1, as the new approaches to measuring capital requirements, particularly those based on internal bank risk estimates, are the most cutting edge, and arguably the most technically complex, part of the new accord. However, the Basel Committee has been keen to emphasize that Basel II will not work effectively if the other two pillars are not properly implemented.

The role of supervisors, captured under Pillar 2, remains important under Basel II. Arguably it assumes an even greater importance, as they will need the technical expertise and judgment to review and monitor the risk rating, risk measurement, and capital allocation practices of banks, as well as to conduct appropriate supervision of the risks not covered directly in the Basel II capital charges (an example being interest rate risk). Pillar 3 is also extremely important and potentially has big implications for banks as the types of risk disclosure required go far beyond the information made publicly available by most banks today.

Pillar 1: The Minimum Capital Requirement

Banks are required to have sufficient capital to cover credit, market and operational risk, the latter being a new element of regulatory ratios, as Basel I had no explicit capital charge for operational risk.

The New Basel II Credit Risk Measures

To address the shortcomings of Basel I, one fundamental innovation under Basel II is the use of credit ratings to provide a more refined measure of a bank’s credit risk exposure.

The Standardized approach to credit risk is designed for banks with less complex operations and activities. For corporate and securitized assets, it allows banks to calculate capital charges based on broad groupings of the external ratings of the claim assigned by a recognized credit rating agency (an “External Credit Assessment Institution” or “ECAI” in Basel parlance).

The IRB approach, intended for banks with more sophisticated risk measurement and management systems, allows banks to determine their capital charges based on internal estimates of risk. While the IRB approach is, at heart, a credit risk model, it has been designed and parameterized by regulators to promote safety and soundness within the banking system. Thus, while some observers talk of “regulatory capture” (whereby regulators have, so the argument goes, given up some of their powers and, in effect, allowed banks to influence the regulatory process by determining their own capital requirement), the reality is that the Basel Committee has devoted much effort to devising formulas and developing stringent operational requirements that help to ensure that its prudential objectives for safety and soundness are satisfied. It is certainly true that banks will have a greater role in determining their capital requirement, but this reflects the fact that the IRB approach is an attempt to bring regulatory capital, i.e. that required by the regulators, more closely into line with economic capital, i.e. the level determined by the banks as needed to cover the various risks to which their businesses expose them.

The objective of the Basel Committee has been to produce capital standards that would not reduce the amount of capital held by banks in aggregate but would align capital requirements more closely with underlying risk – such that banks with lower risk exposure would have to hold less capital than those with higher risks. By providing banks with the option to use more refined risk measures based on internal estimates, Basel II also aims to give an incentive to banks to develop more sophisticated risk management systems. Hence, the impact on overall capital requirements, after factoring in the introduction of the explicit new charge to capture operational risks, is likely to be at best neutral under the Standardized Approach and could be modestly positive (i.e. requiring less capital) under the more advanced Basel II measurement approaches. These trends are broadly reflected in the results of the quantitative impact testing that the Basel Committee has performed on a range of banks globally

As is well known, there are three approaches (The Standardized, the Foundation IRB, and the Advanced IRB) that banks can choose to follow to calculate their minimum capital requirements for credit risk.

 The Standardized Approach

This simple approach represents only a limited departure from Basel I. The main changes are the move away from the flat 8% capital charge for corporate risks to a system with slightly more differentiation of risk, and the move away from using OECD membership as the key criterion for assigning capital charges to banks and sovereigns to a system making greater use of external credit ratings to differentiate credit risk. More specifically, Basel II groups different external ratings into broad categories or “buckets”, with claims in the higher rated buckets generally benefiting from lower charges than those in the lower-rated buckets. For claims on banks, one option (Option 1) sets charges based on the sovereign rating (generally the charge is one notch higher than the underlying sovereign charge) while Option 2 bases the charge on the external rating assigned to the bank itself.

Ratings are also used for evaluating corporate borrowers as well. To help tackle the regulatory “arbitrage” strategies under Basel I, Basel II recognizes the higher risk of subordinated securization positions by assigning more punitive charges to lower rated tranches than an unsecuritised asset with a comparable credit rating. Retail lending generally attracts a more favorable treatment than under Basel I. Another important change under Basel II is that off-balance sheet commitments less than one-year attract a higher conversion factor and, in turn, a higher capital charge than Basel I (which applied a 0% conversion factor to short-term commitments).

Table: Capital charges (risk weightings) under the Standardised Approach



Before allowing ECAIs such as the rating agencies, national supervisor will have to ensure that they fulfill the following standards set by Basel Committee (2004):

(i) Objectivity: The methodology for assigning credit assessments must be rigorous, systematic and subject to some form of validation based on historical experience. Before being recognized by supervisors, an assessment methodology for each market segment, including rigorous back testing, must have been established for at least one year and preferably three years.

(ii) Independence: An ECAI should be independent and should not be subject to political or economic pressures that may influence the rating. The assessment process should be as free as possible from any constraints that could arise in situations where the composition of the board of directors or the shareholder structure of the assessment institution may be seen as creating a conflict of interest.

(iii) International access/Transparency: The individual assessments should be available to both domestic and foreign institutions with legitimate interests and at equal terms. In addition, the general methodology used by the ECAI should be publicly available.

(iv) Disclosure: An ECAI should disclose the information on its assessment methodologies, including the definition of default, the time horizon and the meaning of each rating, the actual default rates experienced in each assessment category, and the transitions of the assessments i.e., the likelihood of AA ratings becoming A over time.

(v) Resources : An ECAI should have sufficient resources to carry out high quality credit assessments. These resources should allow for substantial ongoing contact with senior and operational levels within the entities assessed in order to add value to the credit assessments.

In addition, supervisors will be responsible for assigning eligible ECAIs’ assessments to the risk weights available under the standardized risk weighting framework, i.e., deciding which assessment categories correspond to which risk weights.

Under the Standardized Approach, the calculation of the capital ratio is expressed as follows:


———————————————————–  > 8%

Credit Risk-Weighted Assets + (Operational Risk

Charge * 12.5) + (Market Risk Charge * 12.5)

Standardized Approach: Issues for banks

• The Standardized charges better reflect the credit risk of corporate, bank, and sovereign borrowers than Basel I. This said, by grouping a range of different ratings grades into the same broad risk-weighting “buckets”, Basel II does not harness the full ability of external ratings to differentiate risk. As one example, some investment grade borrowers (i.e., those rated BBB) will receive the same charges as certain non-investment grade borrowers (i.e., those rated BB).
• While highly rated corporates will benefit from lower capital charges, in practice only a small portion of a bank’s portfolio will typically be externally rated. As all unrated corporate exposures will continue to receive the same flat charge of 8% applied currently, it is unlikely that Standardized banks will see their capital requirements on corporate assets change all that much relative to Basel

I. The reduced Standardized charges on retail lending could make such lending more attractive to banks. It will be important for banks with large exposures to riskier customers, particularly sub-prime borrowers, to ensure that they hold an appropriate amount of capital to cover the heightened risk exposure.
• The optional 4% charge for certain types of commercial real estate lending, which national supervisors have the discretion to adopt under Basel II, is, inappropriate for most banks given the generally high risk in commercial real estate lending.
• The Standardized approach could materially impact the charges for claims on banks themselves. The potential “winners” will be bank borrowers from non-OECD countries that were subject to an 8% charge on all long-term claims under Basel I, but could benefit from lower charges under Basel II. For example, investment grade banks (rated “BBB-“ or above) in non-OECD countries will earn lower charges. Additionally, for non-OECD countries choosing Option 1 (which bases charges against bank exposures on the sovereign rating), Standardized banks in countries rated A- or above will also benefit.
• Conversely, potential “losers” include banks in OECD countries that used to receive a 1.6% charge under Basel I, but under Basel II will receive a 4% charge or higher if the bank’s external rating is ‘A+’ or below. For example, banks in OECD countries such as Korea and Japan, which have hitherto attracted a 1.6% charge for both long-term and short-term exposures, may see charges on long-term exposures rise to 4% if the bank is rated ‘A’ or ‘BBB’.
• There will also be winners and losers among sovereigns worldwide, with Asia having more winners, such as ‘AAA’ rated Singapore, for example, attracting a zero capital charge, whereas it previously attracted an 8% charge under Basel I. Other non-OECD investment grade sovereigns, including Taiwan, China, Thailand, Malaysia, will also be likely beneficiaries, as they will attract less than an 8% charge under the Standardized approach based on their current sovereign ratings.
• Basel II will likely reduce the appetite of banks to hold subordinated securitization tranches given the penal treatment of such positions.

The IRB Approach

In contrast to the Standardized approach, which is a relatively modest refinement of the Basel I ratio, the IRB approaches represent a fundamental shift to a regulatory capital system based on the bank’s own internal assessments of its risks. The proponents of the IRB approach argue that increasing reliance on rating agencies in the regulatory process under standardized approach would undermine the initiatives of banks in enhancing their risk management policies, practices and internal control systems. However, adoption of IRB approach will bring new challenges for supervisor as well as banks in developing economies like Bangladesh. The IRB framework is calibrated to cover the bank’s potential economic losses, namely:

• “EL” or Expected Loss, i.e. the mean or average loss a bank can reasonably expect to incur on the assets it holds. These are to be covered by a bank’s loan loss reserves.
• “UL” or Unexpected Loss, i.e. losses that exceed the bank’s expectation and are estimated based on a statistical distribution of potential loss on a credit portfolio, using a 99.9% confidence level (essentially meaning there is a “1 in 1000” chance that the bank’s losses over the next year will exceed the minimum capital charge).The key inputs needed to estimate these losses are:

• PD (Probability of Default), or the likelihood that the borrower defaults over a one year time horizon.
• LGD (Loss Given Default), or the amount a bank would expect to lose in the event of a default (the inverse of the recovery rate).
• EAD (Exposure at Default), which for example reflects the forecast amount that a borrower will draw on a commitment or other type of credit facility.
• Maturity, reflecting the fact that longer term corporate exposures carry higher credit risk.Another critical element of the IRB framework and a key driver of the capital charges are the assumptions around correlation and the correlation values used in the formulas. Basel II does not recognize “full” credit risk modelling and does not permit banks to generate their own internal estimates of correlation, in light of both the technical challenges involved in reliably deriving and validating these estimates for specific asset classes and the desire for tractability.

Different correlation rates are therefore assumed for different types of assets (e.g. residential mortgages is fixed at 15%; credit cards is fixed at 4%; corporate ending ranges from 24% for high quality borrowers down to 12% for low quality borrowers). These correlation assumptions are based partly on empirical work and analysis of industry experience and also on the Committee’s broader policy objectives of calibrating the overall capital charges to a desired prudential level. Indeed, correlation is an important policy lever that the Committee uses in adjusting capital requirements.

Under the IRB, the calculation of the capital ratio differs from the Standardized Approach and can be simplified into:

Capital + (LLR- Credit Risk EL)

—————————————————–  > 8%

(Credit Risk UL x 12.5) + (Operational Risk

Charge * 12.5) + (Market Risk Charge * 12.5)

In effect this is saying that the amount of capital a bank holds must fully cover its UL exposure, with capital being adjusted for any surplus/shortfall in the amount of Loan Loss Reserves (LLR) needed to cover EL. That is, if the bank’s EL exceeds its reserves, then it must deduct this shortfall from its capital block. The ratio above is expressed at the prescribed Basel II minimum of 8%, but national supervisors may decide to set the minimum at a higher level if they deem it appropriate, as has been the practice for a number of countries in their implementation of Basel I.

The Accord has provided two types of IRB approach: (a) Foundation IRB Approach and (b) Advanced IRB Approach.

 Foundation IRB Approach

Under the Foundation IRB approach, banks will provide their own estimates of PD and rely on supervisory estimates for other risk components such as LGD, EAD and M. To do this, they will need a comprehensive grading system and loss data to estimate the default probabilities of the various categories used by the bank. Foundation IRB banks, however, are not permitted to provide own estimates of the other inputs in the IRB formula, and will instead be required to use fixed values specified and provided within the Basel II document. These are:

• LGD: 45% for unsecured loans (see below for treatment of collateral)
• EAD: 75% conversion factor for committed credit lines on unsecuritized exposures
• Maturity: 2.5 years. Advanced IRB Approach

Under the Advanced IRB, banks will be expected to estimate not only PD, but also LGD, EAD and M on their corporate assets based on internal data, subject to meeting the minimum standards. For both the foundation and advanced approaches, banks must always use the risk-weight functions provided in the New Accord for the purpose of deriving capital requirements.

Estimation of the parameters

The critical issues that both supervisors and the banks will face in implementing IRB approach are:

  1.        Historical data to estimate PD
  2.        Historical loss database to estimate LGD
  3.        Historical exposure data to estimate EAD

Various types and characteristics of data are necessary to estimate each of these parameters. Some of them are discussed below from Artigas’s (2004) famous article ‘A Review of Credit Registers and their Use for Basel II’.

Historical data to estimate PD

In order to calculate each bank’s minimum capital requirements under Basel II, banks need to have ready access to an essential information set. As regards PD estimation, the development of an overall borrower rating system requires default information. In addition, the development of an appropriate rating system would require information on certain loan characteristics that could be used, either directly or through data refinement, to construct variables that are sufficient for determining each borrower’s credit quality or, in other words, its probability of default. Among other items, desirable information would be on duration of borrower’s existence in the system, default history of each borrower (number of times that they have defaulted previously, or proportion of defaults in terms of how long they have been in the system), history of an obligor’s rating migrations (upgrades or downgrades), number and type of banks with which obligors deal, past due debt without reaching default status (delinquency status), industry to which obligors belong, type of credit instrument and maturity date. Others financial variables such as leverage ratios, debt burden, efficiency, productivity and profitability in the case of firms, and employment status and indebtedness profile in the case of individuals, along with the stage of the business cycle of the economy, could form the core group of variables needed to estimate a rating system. As per Basel standard, estimation of PD needs to be based on 5 years’ historical data.

Historical loss database to estimate LGD

In the case of LGD, certain readily identified characteristics would be needed to estimate its determinants empirically via a regression model. Calculating LGD properly requires knowledge of type of collateral, percentage of collateral coverage, credit operation’s interest rate, age of operation (time elapsed since loan origination), industry, loan size, loan maturity date, the amount finally recovered, the time taken to recover it, all the costs incurred in the process (from legal costs to the opportunity cost of money), all possible intermediate recoveries and the discount rate to be applied. Since the Accord leaves open the option of making use of external data, LGD can be estimated using market data such as market prices of defaulted loans or bonds. The above information along with other qualitative variables furnished by the departments entrusted with recovery management could also be used for LGD validation. It can be noted that for validation of the LGD the required information structure basically depends on characteristics of the credit operations themselves whereas for PD validation the required data mostly refer to intrinsic characteristics of borrowers.

Historical exposure data to estimate EAD

Regarding EAD validation, information on drawn and un-drawn exposures, particularly in the period of time prior to a default event, is necessary. An analysis of how borrowers make use of their commitments over time would be a good first approximation for validating EAD. Other items such as the number of banks with which a borrower deals, past default history, size of the loan, industry and guarantees appear to be items, which, in principle, may seem to explain EAD. Moreover, an assessment based on qualitative elements could also be a reasonable validation solution.

It is argued that data quality is an important factor that could affect the quality of risk measures generated by the model. Incomplete, imprecise and archaic data may rather increase the risk and the losses faced by banks.

IRB – Issues for banks

• Ratings system design and data quality are key issues for banks planning to use the IRB approach. Very few banks have developed internal credit risk grading systems to manage risk and return. Several banks are now in the process of developing such systems, though these are as yet not fully tested. Additionally, many banks have as a general matter not been systematically collecting and evaluating loss data on their credit portfolio, including recovery data needed to use the Advanced IRB approach.
• An obvious potential challenge for banks seeking to use the IRB is the potential for credit risk loss data to be distorted by economic cycles. Indeed, in using historical data to estimate future potential losses, IRB banks need to consider the greater volatility in business cycles. For example, the losses suffered by banks in the five years following the 1997 Asian Financial crisis were catastrophic in many countries, whereas the losses in the prior five year period were far lower. Using longer-run averages of historical loss data will help to smooth some of these cyclical effects. However, there are practical challenges to doing so. For one, it is unlikely banks will have more than a few years of credible and relevant historical default data. Another issue is how the IRB bank will validate its default estimates. One aspect of validation is to compare PD estimates with the realized default experience for each rating grade. However, if measured over a particularly turbulent period, it is quite possible that the actual experience will not correspond with the bank’s PD estimates, which again are based on historical data. Such a divergence does not necessarily mean that the bank’s risk ratings and quantification process are “wrong”. Indeed, designing a validation process that can identify potential inaccuracies and concerns will be fundamental to a well-functioning IRB system.
• A related issue is the bank’s use of stress scenarios of potential adverse events within their capital allocation. How banks in practice construct and perform these stress tests – and how they build the results into their capital strategy – is a critical aspect of IRB implementation.
• The level of LGD is clearly crucial in estimating potential losses. Is the 45% LGD value for unsecured loans used under the Foundation IRB approach appropriate for Asia? At first sight it appears far too generous in certain instances. For example, in Korea after the 1997 crisis KAMCO (the government-backed asset management company) bought secured NPLs from banks at 45% of face value; unsecured NPLs were bought at just 3%. While this may be an extreme case, loss severities on unsecured lending in most of Asia happens to be higher than 45%. Banks and supervisors will need to consider whether a 45% LGD would understate potential losses and to take this into account by holding an appropriate buffer beyond the minimum regulatory capital requirements.
• The requirement to hold capital against committed lines is more conservative than Basel I. For example, liquidity facilities, unless meeting liquidity and asset quality tests, will generally be treated as direct credit substitutes and hence will attract a capital charge. This could add significantly to the capital charge of banks, such as the large Japanese banks, that are large providers of credit facilities to Asset-Backed CP programs.
• Under IRB, high quality corporate lending will attract a lower capital charge, while low quality borrowers will require a higher charge than the current 8% charge under Basel I. IRB banks therefore face incentives to prefer high quality over low quality borrowers. Standardized banks will have relatively greater incentive to lend to lower quality borrowers, particularly those that are not externally rated, given that these will continue to attract an 8% capital charge irrespective of the underlying risk. The possibility that high risk borrowers will migrate to Standardized banks is a concern for Asia given the risk it poses for less sophisticated banks.
• Beyond the above data concerns is the more fundamental question of whether such calculations can be meaningfully applied in Asia. For example, a key pre-requisite for estimating LGDs is an efficient and predictable legal framework which enables creditors to reasonably anticipate the amount they will recover upon default. In some countries, Indonesia, China and India being notable examples, such a legal system is not yet in place. Even in other countries, Philippines, Thailand and Malaysia being examples, the process of recovering defaulted loans through the repossessions and disposal of collateral can take many years. Since the crisis this has been a particular problem given the large number of NPLs to be dealt with.

 Impact of Basel II credit risk charges

Having provided an overview of the options under Basel II for measuring credit risk (i.e., Standardized, Foundation IRB, Advanced IRB), we turn now to how these approaches might affect the capital charges on various types of activities and assets, including retail lending, commercial real estate lending, collateralized lending, exposures hedged by guarantees and credit derivatives, and equity investments.

 Retail Lending

Under the Standardized approach the capital charge for retail assets will decrease significantly, with the charge for residential mortgages reduced from 4% (50% risk weight) to 2.8% (35% risk weight) and other types of retail exposures (i.e. small scale and highly diversified lending to individuals and small businesses) qualifying for a 6% charge (75% risk weight). The criteria for small business loans to qualify for retail (as opposed to corporate) treatment are that they should be revolving facilities in a diversified portfolio with a maximum size of EUR1m.

An important element of the Basel II retail treatment is the capital charge for the unused portion of credit lines, which could materially affect credit card lenders given that such unused lines generally qualified for a 0% credit conversion factor and hence a 0% capital charge under Basel I.

For retail exposures there is no distinction between Foundation and Advanced IRB. All IRB banks will be expected to calculate the PD, LGD and EAD on its retail portfolios. There is no explicit maturity adjustment, as the differences in tenor of retail assets is reflected in part in the differing correlation values (e.g. residential mortgages are subject to a higher correlation assumption than other types of retail lending).

The IRB retail portfolio is sub-divided into the following categories:

Credit cards, which include not only drawn exposures, but also undrawn lines.

Residential mortgages, which is geared to owner-occupied residential property, however regulators are permitted some flexibility in extending it to rental properties in buildings containing only a small number of rental units.

“Other” retail lending, which includes lending such as auto loans, student loans and small business loans (under EUR1m).

Type of Lending                                  Correlation Factor (%)

Residential Mortgages                             15

Credit Cards*                                         4

Other Retail Loans                                 A Range of 16% to 3% depending on the PD of the Borrower

* And other qualifying revolving retail exposures.

Source: Fitch, Basel Committee.

An important difference between the Standardized and IRB approaches to retail lending is that, while Standardized banks apply fixed charges irrespective of borrower quality, the IRB charges will vary as a function of the borrower’s risk profile. For example, as shown in the chart, the curve for residential mortgages produces a capital charge of 2.8%, equal to the Standardized approach charge, when the PD is just under 3% and assuming an LGD of 15% (which seems generally consistent with typical recovery rates on this type of lending). Thus, Standardized banks will face lower charges than IRB banks on riskier borrowers (i.e., those with higher PDs and LGDs) – and likewise will face higher charges than IRB banks on higher quality borrowers. This means that Standardized banks will have an incentive to take on lower quality mortgage borrowers, while IRB banks have an incentive to focus on better quality (i.e., low PD, low LGD) borrowers.

 Commercial Real Estate Lending

Commercial real estate (“CRE”) lending generally receives an 8% charge under the Standardized approach, although certain forms of CRE mortgage lending are eligible for a 4% charge.

For IRB banks, Basel II differentiates between two different types of CRE lending:

1. “IPRE” or Income Producing Real Estate, i.e. more stable real estate lending with more predictable loss patterns.

2. “HVCRE” High Volatility Commercial Real Estate, i.e. lending with less predictable patterns, such as acquisition, development and construction lending. HVCRE is deemed to be higher risk than IPRE and is thus subject to higher capital charges (which in practice is achieved through higher correlation values at the higher quality or low PD end of the credit spectrum)

Retail Lending: Issues for Asia

• The reduction in charges on residential mortgage lending under Basel II is probably appropriate for at least some Asian banking systems, as this has generally been a safe form of lending. In some countries (e.g. Taiwan, Philippines, Malaysia), however, defaults on such lending have at times been high, and it will be important for banks in these markets to hold a level of capital that is more commensurate with historical experience.
• The 6% capital charge for credit cards under the Standardized Approach appears low for most Asian markets, as this would, for example, correspond to the same IRB charge on a credit card asset with a 3% PD and 85% LGD (see chart below). By way of background, losses on credit card lending have been quite severe in parts of Asia in recent years, with annualised charge-offs in some recent years exceeding 10% in Hong Kong and 20% in Korea. For IRB banks, therefore, it will be critical to forecast the level of risk inherent in these markets and, in turn, hold sufficient capital and build appropriate reserves to weather the potential loss. To the extent that banks appear to be consistently underestimating the risk, supervisors will need to ensure that banks hold sufficient reserves and capital beyond the regulatory minimum.
• On a related point, the borrower mix within the bank’s retail portfolio is an important risk driver, particularly if the bank has large exposure to the Sub-prime market. The higher risk of Sub-prime borrowers to some extent should be captured through (presumably higher) PD estimates. This said, the IRB curves are designed to capture a range of borrower profiles and hence might not appropriately capture the unique risk attributes of a portfolio that is heavily weighted towards the Sub-prime market.
• The Korean credit card debacle also highlights the problem of seasoning: rapid growth in a portfolio during an economic boom may give rise to losses only after a few years. Under Basel II banks are encouraged to anticipate such possible deteriorations and adjust their PD estimates upwards for anticipated seasoning effects. How banks actually reflect the impact of seasoning in these estimates will be an important practical challenge for banks to address.
• The extensive use of “re-aging” by Korean card lenders resulted in serious distortions that masked the true level of defaults and would therefore have led to a significant understatement of PDs. This is another area where the second and third pillars assume great importance, as regulators (who are invited to establish more specific requirements on re-ageing than the Committee proposes) will need to ensure that lenders are not artificially holding down default rates, while enhanced disclosure will make it harder for them to do so.

Banks able to produce loss estimates on commercial  real estate exposure can use one of the IRB approaches to corporate lending – Foundation IRB if they can estimate PDs and Advanced IRB if they have comprehensive recovery (or LGD) data as well.

If banks are not able to generate their own loss estimates, and hence cannot use the IRB formulas, they are to use a “Supervisory Slotting” approach, which in simple terms means that banks will determine the risk level by classifying their exposures into broad categories (e.g. “strong”, “good”, “satisfactory”) etc which and are based on criteria laid down by the Basel Committee and are roughly designed to correspond to rating agency categories (e.g., the “strong” category broadly corresponds to the ‘BBB-’ category and above ).

 Credit Risk Mitigation

One of the features of Basel I that frustrated banks that had relied heavily on collateral-based lending, i.e. most banks in Asia, was that it recognized only very limited credit risk mitigation arising from collateral (essentially only cash and OECD government securities) and guarantees from OECD banks and sovereign entities. Basel II expands the range of collateral significantly, introduces a wider range of guarantors and for the first time recognizes credit derivatives as being economically similar to guarantees.

Guarantees and Credit Derivatives

The universe of eligible guarantees will be extended to include corporate entities (including insurance companies) rated ‘A-’ or better as well as securities firms. In general, Basel II requires the use of a “substitution” approach (the risk weighting of the guarantor replaces that of the underlying claim). The substitution approach, however, does not fully recognize the economic benefits provided by guarantees and credit derivatives, since in practice both the obligor and the guarantor must default before the lending bank suffers a loss on the guaranteed exposure (i.e., the “double default” effect). The substitution approach essentially implies that the performance of the borrower and the guarantor are 100% correlated – a clearly conservative assumption. The Basel Committee is in the process of working on a way to recognize “double default” effects; however a complicating factor in developing a more risk-sensitive treatment is that it would require banks to be able to measure the likelihood that the borrower and guarantor would in fact default at the same time — which would run counter to the Basel Committee’s decision not to permit banks to measure correlation internally.


Basel II greatly expands the types of financial collateral banks can recognize to include sovereign debt rated BB- and above, all other debt rated BBB and above, listed equities, mutual funds, and gold.

The essence of the new Basel II approach to financial collateral is that it recognizes that the price volatility of the collateral instrument is an important factor in the level of risk protection provided. That is, more volatile collateral is more likely to drop in value and hence reduce the amount that the lending bank is able to recover upon a borrower’s default. Thus, the treatment of collateral for Standardized and Foundation IRB banks moves beyond simple substitution by requiring that banks reflect the value of collateral by applying a “haircut” to reflect the market volatility of the particular instrument. Riskier instruments face higher haircuts, with, for example, cash receiving a 0% haircut and certain equities subject to a 25% haircut.

As an example of the more sophisticated credit risk mitigation techniques allowed by Basel II, a ‘B-’ rated borrower provides as security for a USD100 loan a sovereign bond of 10-year maturity that is rated ‘BBB-’. The bond would be assigned a 6% haircut under Basel II to reflect the volatility of an instrument with these risk characteristics. Applying the 6% haircut means that USD94 of the value of the bond can be recognized as collateral. The lender would have to hold capital against the remaining USD6 of unsecured exposure to the ‘B-’ borrower, resulting in a charge of USD.72 (USD6 x 12% charge for ‘B-’ exposures). Thus, the risk on the portion of the loan covered by the collateral, after reducing the collateral by the relevant haircut, is deemed to be fully extinguished by the presence of the collateral. Therefore, the total capital charge on this loan is just 0.72% – far below both the capital charge on the underlying loan (12% if it was unsecured) and the collateral itself (4% assuming a 50% risk weight for a ‘BBB-’ rated bond).

Advanced IRB banks are permitted to recognize the impact of collateral directly in their LGD estimates, based, for example, on the historical recovery experience for different types of collateral.

Standardized banks are not permitted to recognize physical collateral (other than the exception noted above for mortgage lending secured on commercial real estate deemed exceptionally safe, whereby regulators can apply a 4% charge instead of the 8% charge if it meets certain (demanding) conditions, such as a low loan-to-value ratio).

IRB banks, on the other hand, are allowed to recognize the risk mitigation provided by physical collateral. Foundation IRB banks are allowed to recognise residential and commercial real estate, as well as other types of physical assets and receivables, as eligible collateral. Real estate collateral and receivables can, however, only reduce the minimum LGD to 35% (40% in the case of physical assets) and this only in cases where there is at least 140% over-collateralization. The portion of a loan not covered by this level of over-collateralization would receive the standard LGD for unsecured lending, i.e. 45%. Advanced IRB banks are not subject to these limitations, but rather must recognize the collateral impact directly in their LGD estimates.

Loan Loss Provisions under Basel II

The implementation of Basel II will likely affect the way banks provision for credit losses, particularly under the IRB approach. In this regard, it will be interesting to see how Basel II will interact with the complex interplay of accounting and other regulatory considerations that factor into bank reserving practices.

The treatment of provisions does not change much under the Standardized approach. There is some room for banks to obtain a lower charge on past due assets if certain provisioning thresholds are met (e.g., Standardized banks can apply an 8% charge instead of a 12% charge against past due loan if provisions exceed 20% of outstanding amount).

Under the IRB approach, banks will be expected to set up sufficient loan loss reserves to cover their EL exposure, while the minimum capital charges are designed to cover the bank’s UL exposure. As noted, EL represents the mean or average loss a bank can reasonably expect to incur on an asset. Thus, addressing EL through a bank’s reserves should have a positive impact on linking provisioning practices to a quantitative, rigorous estimate of economic loss.

Under the IRB approach, any shortfall in reserves, below the level of EL, is to be deducted from the banks’ capital (equally from Tier 1 and Tier 2 capital). Any excess reserves over and above the amount of EL can be added to capital, but only to Tier 2 capital and subject to a limit of 0.6% of RWA. This treatment appears to be a disincentive for banks to either under- or over-provide, suggesting that the Basel Committee wanted to set incentives for banks to reserve in line with, but not much beyond, their EL exposure.

Potential problems could arise to the extent that Basel II and IFRS provide differing guidance on the level of reserves a bank is expected to establish. Put simply, Basel II’s concept of EL, devised by regulators concerned about bank soundness, is a statistically-based forecast of the economic loss that can be reasonably expected to occur. This might result in a differing level of provisions than would be established under IFRS, which are limited to “objective impairment” (IAS 39) either individually or collectively for a group of loans/assets with similar risk characteristics.

An additional complicating factor is that national regulators may lay down their own country-specific loan loss reserve requirements, including the maintenance of general loan loss reserves at a level that may exceed reserves allowed under IFRS. The importance of tax rules cannot be overlooked since they are often a factor influencing bank’s provisioning levels, although it will likely be more difficult under IFRS to make tax-driven loan loss provisions.

It is not yet clear how these factors will interact and whether (and to what extent) accounting loan loss reserves under IFRS will differ from a regulatory EL-based approach to reserving under Basel II. More significantly, accounting and regulatory capital will increasingly diverge in other areas. A notable feature of IFRS, similarly to US GAAP, is the much narrower definition of “equity” vis-à-vis “debt”, excluding not only hybrid capital instruments that have been allowed in limited amounts as Tier 1 capital by regulators, but also many preferred shares, which, because of their obligation to pay a “fixed” return, are deemed to have debt-like characteristics.

 Equity (Investments) in the Banking Book

The treatment of equity investments was one of the weaknesses of Basel I since it is clear that an 8% capital charge for equities – the same as for high quality corporate debt – is generally not sufficient to cover the risk, particularly given that equity serves as a first loss position and is more subordinated in the firm’s capital than debt. IRB banks can use one of two possible approaches to assessing charges against equity investments.

One option is the market-based approach, allowing IRB banks to use an internal VAR model subject to certain floors (minimum capital charge of 16% for publicly quoted stocks and 24% for private). Banks unable to model the risk would apply fixed-risk weights to the equity exposure (e.g. 24% capital charge on publicly-traded equities). The other option is a “PD/LGD” approach based on the Foundation IRB for corporates, i.e. the bank estimates the default risk and then applies a 90% LGD and five-year maturity

 Qualifying for IRB: What Banks Need to do

Banks wishing to qualify for IRB are required to meet certain standards concerning their rating system and process, their risk measurement, as well as the oversight and governance of their ratings system. The aim is to provide supervisors with comfort that banks are able to assess, differentiate and quantify their credit risk exposure in a consistent and credible manner. The standards appear broadly consistent with the “best practices” of the banking industry.

Much of the formal responsibility for reviewing and monitoring banks’ abilities to meet these standards lies in the hand of national regulators. However, it is also important for banks to communicate to the market information about their ratings processes and risk measurement techniques, including their use of historical loss data.

The Rating System

A bank’s rating system is expected to differentiate risk of different borrowers in a meaningful way. As evidence of this, a bank’s rating scale must not only have a sufficient number of rating categories (the IRB minimum is seven grades for performing assets), but credits must be distributed across the different categories (i.e. a preponderance of loans in the same category would suggest an ineffective system).

Importantly, ratings must be clearly defined and based on meaningful criteria. In short, the ratings must provide both an ordinal (a ‘BBB’ credit must be better than a ‘B’ etc); and cardinal measure of risk (e.g. a ‘BBB’ is associated with a specific PD value).

Ratings Philosophy

A critical factor in understanding a bank’s measure of credit risk under Basel II is its internal ratings philosophy and the horizon of its ratings assessments. Some banks choose to rate by taking into consideration possible stresses through the business cycle (a “through-the-cycle” approach). Other banks use more of a “point-in-time” approach, reflecting the impact of fluctuations in the business cycle through frequent and aggressive rating changes. The bank’s rating philosophy will therefore influence the volatility of ratings, the distribution of credits across different rating categories, and the default rates associated with each category.

Basel II appears to give banks the flexibility to follow either type of ratings approach. On one hand, IRB banks are expected to forecast their default risk over a one-year horizon, which would capture only a portion of the cycle and thus suggest a point-in-time perspective. However, banks are required to use longer-run averages of annual default rates when estimating PD (at least 5 years) and are expected to use a “longer time horizon” in assigning ratings, which would indicate more of a through-the-cycle approach. In evaluating capital adequacy, supervisors will need to understand the nuances of each bank’s ratings approach and risk assessment horizon, particularly in light of the generally more volatile, cyclical performance of financial markets.

Use of Historical Loss Data

To understand a bank’s internal risk-rating system and credit risk measurement approach, the bank’s use of historical data to derive loss estimates for each rating grade needs to be assessed. IRB banks will need to have a minimum of five years of data to measure PD and seven years of data for LGD (five years of LGD data are needed for retail assets).

However, these are minimum standards and banks will need to carefully assess whether the data history they use is both sufficient to address risks across the market cycle and whether it is a relevant benchmark for the bank’s own actual portfolio.

Data is also critical in how banks validate their loss estimates. One aspect of validation is to analyze the bank’s predicted estimates against the actual realized experience. However, differences between the two do not necessarily mean the bank’s risk ratings are not functioning properly. For example, in periods of extreme market volatility, more recent loss experience will likely exceed the longer-run historical averages used to help generate the bank’s PD and LGD estimates. Thus, validation should extend beyond such data comparisons and more broadly address the bank’s processes for estimating risk.

Oversight and Governance

IRB banks are expected to have a strong system of controls to promote the integrity of their ratings and avoid potential conflicts of interest in the ratings process. Specifically, the Board and senior management must have a good understanding of the rating system and be able to make informed decisions on any material changes in risk management practices. Basel II also advocates that banks have an independent control unit that monitors the ratings process.

A broader component of corporate governance is that bank’s meet the so-called “use test” – that is, the risk ratings process should serve as an integral part of the bank’s business activities (e.g., pricing), daily operations, and strategic planning, and not just a regulatory compliance tool. The “use test” thus helps promote the broader dissemination of a risk-focused culture and decision-making process.

 Capital Charge for Operational Risk

In addition to the more refined measurement of credit risk, a key innovation of Basel II is the introduction of an explicit capital charge for operational risk. Basel II defines operational risk as “the risk of loss resulting from inadequate or failed internal processes, people and systems”. It includes legal risk but excludes reputation risks and indirect losses, which are difficult to quantify but should still be addressed within a bank’s risk management strategy.

There are three approaches to calculating a capital charge for operational risk.

1. The Basic Indicator Approach, which sets the capital charge at 15% of the average annual gross income for the previous three years. (Gross income excludes any provisions and exceptional items, insurance income and any sales/losses in the banking book.)

2. The Standardized Approach under which annual gross income is broken down by business line and different weights are assigned:

Business Line                                      (%)

Corporate Finance                                  18

Trading & Sales                                     18

Retail Banking                                        12

Commercial Banking                               15

Payment & Settlement                            18

Agency Services                                     15

Asset Management                                 12

Retail Brokerage                                    12

Source: Fitch, Basel Committee

3. Advanced Measurement Approaches (“AMA”). Under the AMA the capital requirement is based on the amount of operational risk exposure calculated by the bank’s internal system, which must meet data and measurement criteria prescribed under Basel II and is subject to regulatory approval

Operational Risk: Issues for Banks

• A recent survey by Fitch on banks in developed countries found that a majority of banks had internal loss data covering less than two years and most of the rest had less than five years of data. Fewer than 5% of banks had more than the prescribed Basel minimum of five years of operational loss data. Most banks, therefore, are still at an early stage in terms of identifying risk areas and collecting data. The same is true of most banks in Asia, very few of which will be in a position to implement the AMA approach for operational risk by 2007, the Basel II implementation date for the advanced approaches.
• Most banks are therefore likely to start with either the Basic Indicator or the Standardized approach. Given that the calculation is based on gross income, the resulting capital requirement could be quite substantial, potentially offsetting the capital saving arising from the assignment under Basel II of lower charges for higher quality credit risk exposures. This view has been frequently expressed by a number of banks, namely that Basel II will result in some capital reductions on credit risk exposures but that this will be partly, or completely offset by the new capital requirements for operational risk.
• Banks could potentially benefit from relatively lower operational risk charges under the AMA. More importantly, however, movement towards the AMA will promote the collection and analysis of operational loss data and the more systematic assessment of this risk. Therefore, as a longer term objective, it is important for the larger, more sophisticated banks to build up their operational risk measurement capabilities.

Definition of Capital and Market Risk Rules Essentially Unchanged

The definition of capital remains essentially the same as under Basel I. One exception is the treatment of excess/deficient Loan Loss Reserves which under the IRB framework will be added to or deducted from capital subject to certain limits.

Market risk is also largely unchanged by Basel II and remains as defined by the 1996 Market Risk Amendment, although the definition of the trading book has been further clarified. This said, an important issue under Basel II will be how the border between the trading book and the banking book is observed in practice.

Transition Period

Given that Basel II, notably the IRB for credit risk and AMA for operational risk, represents a fundamental paradigm shift in how risk-based capital is measured, the Basel Committee has instituted minimum floor requirements to prevent a sudden drop in capital charges, as per the following table:

 Pillar : The Role of Supervisors under Basel II

National supervisors are expected to play an important role in the effective implementation of the new framework.

For one, in several areas under Pillar 1, Basel II provides national supervisors with discretion over certain elements. Even a brief review of the discussion below will highlight the extent to which supervisors can either enforce prudence and conservatism or could potentially undermine the integrity of the capital requirements.

More broadly, national supervisors are responsible for ensuring that banks hold a sufficient amount of capital to cover their underlying risk. This responsibility is particularly important in reviewing the quality of the risk measurement systems of banks using the more advanced approaches (i.e., IRB and AMA) and when addressing elements of risk not captured directly in the Pillar 1 ratios.

Supervisors will need to monitor and review bank’s internal rating systems and the resulting loss estimates. One important area to monitor is the bank’s process for validating its ratings assessments and loss estimates. Supervisors will want to make sure that banks are comparing their PD (or cardinal) estimates for each rating grade against actual default experience. However, particularly during periods of market volatility, it is quite possible that realized default rates will diverge from the bank’s estimates. Therefore, further analysis would be needed to distinguish whether the cyclicality of the market is driving this divergence, or whether the bank’s ratings are in fact flawed. How to validate the ratings assessments of IRB banks is therefore a critical issue facing supervisors in a Basel II world.

One important discipline is for supervisors to look more broadly at the bank’s ability to differentiate risk on a relative (or ordinal) basis – that is, do higher-rated credits perform better than those in lower rating categories. Supervisors also need to monitor whether bank’s ratings and risk assessments are suitably conservative in taking into account possible adverse developments, so as to ensure that banks remain adequately capitalized throughout the economic cycle. For example, in the context of LGDs, Basel II recognizes the possibility that recent loss experience may not fully reflect future recovery prospects and hence expects IRB banks to reflect “economic downturn conditions” in their estimates. Basel II notes that for some exposures loss severities will vary over the economic cycle. Thus, it is important for banks to incorporate these cyclical relationships into their LGD estimates. How banks in practice build downturn scenarios into their recovery estimates is a critical area for supervisors to understand and monitor.

In this regard, stress testing is an extremely important mechanism for banks to allocate sufficient capital over the economic cycle, particularly to weather potential market distress. During economically buoyant periods with low credit losses, banks might respond to their improving Basel II ratios by repurchasing shares or otherwise lowering their capital base. In these instances, it will be important for supervisors to understand the bank’s overall capital strategy and how carefully it assesses the possibility of a turn in the market, particularly through stress testing.

Supervisors will also need to be attuned to risks not captured in Pillar 1, particularly risk concentrations. Indeed, the Pillar 1 ratios do not distinguish between a well-diversified institution and one with concentrated exposure to a few single borrowers, geographic regions, product areas, or business sectors. A challenge facing supervisors will therefore be to determine how well the bank is evaluating and measuring the different forms of concentration risk it may face, how well it is able to aggregate these concentrations, and its strategy for mitigating and managing this risk.

Interest rate risk in the banking book is also not addressed in the Pillar 1 ratios and is therefore an important area for supervisors to monitor. Basel II lays out guidelines for how supervisors can better monitor a bank’s interest rate risk exposure, including scenario analysis of the impact of interest rate shocks. However, particularly in countries with more volatile rate environments, supervisors should look carefully at the bank’s overall asset and liability management strategy and ensure that they are prudently positioned or hedged against abrupt changes in interest rates.

Pillar : Market Discipline

The third pillar of Basel II (“Pillar 3”) establishes more rigorous standards for a bank’s disclosure of its risk profile and capital. The purpose of these disclosures is to leverage the ability of market participants to deter banks from taking on undue risks. The minimum Pillar 3 disclosure requirements cover the bank’s capital structure (i.e., components of Tier 1 and Tier 2 capital) and key pieces of information that go into the calculation of its Basel II risk exposure. For example, IRB banks must disclose the default estimates associated with each ratings category and actual loss experience by portfolio on an annual basis. Pillar 3 also sets forth qualitative disclosures that help to explain or clarify the bank’s risk measures. For example, IRB banks are expected to discuss the key factors impacting loss experience or higher than average LGDs and EADs.

Fitness of the various credit risk measurement approaches for Bangladesh

Standardized Approach:

It is argued that in many countries, low rating penetration and a lack of domestic rating agencies may pose a challenge for implementation of the standardized approach, particularly in respect of corporate claims. This is not untrue for Bangladesh where the rating industry is not advanced enough and the majority of the individual claims of bank loans remain unrated. Currently two rating agencies, namely CRISL and CRAB, are operative in the financial market. If the standardized approach is adopted, it is highly likely that regulation may force the banks to rush to them. Since banks in Bangladesh are linked with tens of thousands of borrowers, the capability of these two rating agencies in terms of credit assessment of those borrowers within the regulatory timeframe may not be sufficient. Adopting SA without having sufficient number and depth of rating agencies may also cause other problems. For example, cost of credit assessment may be substantially increased due to high regulatory demand for this service. This, in turn, may increase lending price and may affect banks’ profitability.

The Accord requires that the assessment process should be as free as possible from any constraints that could arise in situations where the composition of the board of directors or the shareholder structure of the assessment institution may be seen as creating a conflict of interest. However, the existing Credit Companies Rules that was enacted in 1996 to regulate the business of credit rating agencies has not considered this issue in line with Basel’s new standard. It is understood that directors of the existing rating agencies are directors of the scheduled banks as well as directors of other public and private companies. This type of conflict of interest may cause for rating-biases and need to be addressed urgently through legal changes before adopting the standardized approach. High default culture in the financial market of Bangladesh indicates that existing weak regulatory framework for rating agencies may influence borrowers’ behavior to obtain good rating inappropriately. Therefore rating regulations need to be updated to address such potential problems. A conference (Effects of Implementing Basel II in Emerging Markets) was held in Panama on 13 April 2004 where it was concluded that the “Full” Standardized Approach cannot function properly without an adequate regulatory framework for credit rating agencies. On the other hand, it expressed concern on the role of credit rating agencies for two major reasons: (i) the track record of these agencies in their region in assessing risks was not satisfactory and (ii) the use of credit rating for the purpose of determining required capital might result in biased ratings of borrowers.

It can be noted that credit risk modeling, back-testing and forecasting require high level knowledge of probability statistics, financial econometrics and times series analysis. It is yet to be ascertained whether the existing rating agencies have sufficient qualified human resources who can perform those activities in a professionally competent manner. Since rating greatly depends on long historical data, given that the industry is of recent origin, it can be assumed that they may not have sufficient database to validate their models.

 IRB Approach

To make a choice between the two IRB Approaches, their appropriateness in the existing market conditions need to be assessed. Both of these approaches, in fact, require risk modeling by the banks themselves. Since risk modeling is a new concept for the banking sector of Bangladesh, it can therefore be assumed that banks do not have adequate trained human resources in this regard. Between these two approaches, Advanced Approach is more sophisticated than the Foundation Approach. Adoption of the Advanced Approach requires the banks to have some years of practical experience in exercising risk modeling and forecasting. Accuracy of these models in calculating risk needs to be examined and validated. In this matter, another important point needs to be considered. Advanced Approach will allow the banks to determine LGD and EAD independently. Since these two variables are inputs in the calculation of minimum capital requirement for credit risk, manipulation of these two variables by the banks may significantly change their capital requirement. Considering the above factors, it can be argued that the Foundation Approach seems to be more appropriate than the Advanced Approach in the banking sector of Bangladesh.

Since other countries, like Bangladesh, will face some common challenges, it would be better to look into the examples of other nations. A survey conducted by Financial Stability Institute (FSI, 2004) has indicated that globally more than 100 countries are going to implement new Basel Accord. However, in measuring credit risk and calculating minimum capital requirement against it, the highest percentage of banking asset will be subject to IRB Foundation Approach followed by Standardized/ Simplified Standardized Approach


It can be argued that if some economies have greater banking asset and they follow a common approach, the entire survey result may be biased in favor of that approach and may not properly indicate what approaches are likely to be adopted by major nations. Therefore, the survey’s result has been again disaggregated by excluding the jurisdiction with the highest banking assets. The result indicates that though IRB Foundation Approach is likely to be subject to the highest percentage of banking asset (figure 9), standardized/simplified standardized approach is more likely to be adopted by the major nations in Asia (figure 10).

9), standardized/simplified standardized approach is more likely to be adopted by the major nations in Asia (figure 10).

If examples of other nations are considered, it can be argued that Advanced IRB is not a suitable option for Bangladesh, which leads a choice between Standardized Approach and Foundation IRB Approach. As mentioned earlier, Standardized Approach may not be a suitable option for Bangladesh due to the lack of adequacy of rating agencies, weak legal framework and possibility of cherry picking of rating biases. However, Bangladesh may follow either Standardized Approach (SSA) or Foundation IRB Approach.

Again, between the SA and IRB Foundation Approaches, which approach is likely to be more appropriate for Bangladesh? Answer to this question is not straightforward. SSA does not require any major preparation by banks and the supervisor. In this case, as like as Basel Accord I, banks will have to arrange their assets into different categories and multiply them by the corresponding risk-weight provided in the New Accord in order to find risk-weighted asset. However, recent changes in the banking sector in terms of risk management practices signal that banking system is gradually becoming conducive to the adoption of IRB Foundation Approach. For example, Bangladesh Bank vide BRPD (Banking Regulation and Policy Department) Circular No. 18, dated December 11, 2005 has introduced Credit Risk Grading Manual for all the scheduled banks in Bangladesh. It will enable the banks to be familiar with risk modeling. Notwithstanding a lot of work still needs to be done. For instance, the Manual provides some qualitative grading depending on some quantitative measurements. These qualitative criteria need to be translated into different risk categories. The modeling methodology needs to be updated to be consistent with the New Basel Accord. As per IRB Foundation Approach, borrower’s past default information such as default history of each borrower (number of times that they have defaulted previously, or proportion of defaults in terms of how long they have been in the system), history of an obligor’s rating migrations (upgrades or downgrades), past due debt without reaching default status (delinquency status) are prime inputs for risk grading which are not properly considered in the above Manual. Likewise international bank guarantee has been included in the category of superior risk grading such as 100 percent cash cover and government guarantee. In the Basel Accord II, minimum risk-weight for a AAA to AA- rated bank is 20 percent. These kinds of inconsistencies need be revised. Besides, risk rating mapping process as per Basel norm needs to be developed.

As a supervisor, the Bangladesh Bank will require to provide supervisory formula to determine LGD and EAD depending on the types of credit and their sectoral exposures. In this case, the role of Credit Information Bureau (CIB) in storing and disseminating credit information needs to be redefined. For example, estimation of PD requires 5 (five) years’ previous data and estimation of EAD and LGD require 7 years’ past data. At present, Credit Information Bureau (CIB) of Bangladesh Bank stores information on borrowers of the banks and non-bank financial institutions. Once a borrower repays its past default debt, its status is updated a never-defaulted good borrower. The new Accord requires storing such default behavior of the borrower. In order to estimate risk components such as LGD, EAD and M, Bangladesh Bank, as a supervisor, will require getting information on sector-wise credit exposures and their default trend. It can further be mentioned that borrower’s credit information from CIB has been made compulsory only for big loans; adoption of Foundation IRB Approach requires credit information even for small borrowers. Consequently, adoption of IRB approach will require CIB to redesign its information system.

Since adopting the Foundation Approach requires the supervisor to examine and validate banks’ internal credit risk models, adoption of this approach requires equipping Bangladesh Bank’s relevant staffs.

  Final Decision by Bangladesh Bank:

Due to the advantages and disadvantages of the various approaches, the steering committee of Bangladesh Bank on Basel II Accord finally decided in NOV06 to adopt the following road map for implementation of Basel II in Bangladesh after seven months of spadework. The decisions were based on various factors like the existing structure of the banking industry, presence of required infrastructure, human resource development and technological capacity, time period remaining for Basel II implementation etc.

Credit RiskBasel I will continue in effect until 31DEC08. Migration to Basel II under the Standardized Approach from 01JAN09.
Market RiskWith effect from 01JAN09, under the Standardized Approach
Operational RiskWith effect from 01JAN09, under the Basic Indicator Approach

Bangladesh Bank noted in the meeting that based on the current scenario, it might take several years for Bangladesh to move in to the Advanced Approaches.

The Central bank in a recent circular also made it mandatory for all banks to have themselves rated by a credit rating agency (CRA) effective from January 2007. Bangladesh Bank will also go for a quantitative impact study to assess the possible impacts of the implementation of the Basel II accord in the country’s banking sector, sources said.

Two high-powered committees are now working for formulating policy and supervising the Basel II implementation process. The central bank deputy governor, Muhammad A (Rumee) Ali, heads the nine-member steering committee while the executive director, Asaduzzaman Khan, chairs the 21-member coordination committee.

 Implications for HSBC Bangladesh of Basel II implementation

As discussed earlier, the Basel II Framework will also apply to all internationally active banks at every tier within a banking group, also on a fully consolidated basis. This means that subsidiaries or country offices of an internationally active bank operating in a certain jurisdiction will have to meet the capital adequacy requirement set out by the local regulator, while the holding company of the bank or the group will also have to meet the capital adequacy requirement on a consolidated basis in its country of incorporation.

HSBC being an internationally active bank and having its registered office in UK, the implication for HSBC Bangladesh is that it will have to follow the credit risk approach set by Bangladesh Bank on a local level, while at the same time following the credit risk approach set by the group.  As it happens to be, HSBC Group, on the whole, has decided to follow the IRB – Advanced Approach, which is more advanced than the Standardized Approach prescribed by Bangladesh Bank.

In order to benefit its’ global business, HSBC’s strategy is to progress wherever feasible towards IRB-Advanced approach to cover all of core credit risk exposures. The FSA has already endorsed HSBC’s plan to adopt the IRB Advanced approach for Credit Risk with effect from 1st January, 2008 on the basis of a roll out plan that will achieve 85% coverage by 2010.

The impact of this is that:

• Parallel running for FSA (and FRB) purposes will start on 1st January 2007.

• Public disclosure will commence during 2008 with Basel II RWAs calculated on a basis of a combination of Standardised, IRB-F and IRB-A as appropriate.

• HSBC UK (HBEU) and HSBC USA & Canada (HNAH) and HSBC Mexico (HBMX) has commenced a two-year experience requirement for IRB Advanced Approach (IRBA) starting on 1st January 2006 to enable those entities to be treated as IRB effective 1st January 2008.

• HSBC Asia Pacfic (HBAP), of which HSBC Bangladesh is a subsidiary, will commence reporting IRBA on 1st January 2009, HSBC France (HBFR) & HSBC Germany (HTDE) on 1st January 2010.

Changes Already Introduced in Credit Evaluation Processes

In order to prepare for the adoption of the IRB Advanced Approach, some groupwide changes have already been introduced in HSBC.

  • HSBC in the past has been very thorough in maintaining essential default information set. This has allowed HSBC to develop a rating system that can be used for determining each borrower’s credit quality or, in other words, its probability of default. This is known as Customer Risk Rating (CRR) Scale (discussed earlier). The CRR, which is a two dimensional methodology that separately assesses the risk of borrower Probability of Default (PD) and the risk of likely loss in the event of default, is replacing the judgmental Facility Grade (FG) 1-7 approach that was used earlier to rate a client.
  • The credit evaluation process is clearly segregating the components of a risk profile assessment i.e. Probability of Default (PD), Loss Given Default (LGD) and Exposure at Default (EaD) to quantify transaction risk.
  • Introduction and use of an internal ratings based scorecards (called Moody’s Financial Analyst) is being used to derive PD% (Probability of Default) that is being used on the 22 point logarithmic Customer Risk Rating Scale (CRR)
  • Policies and procedures have been published to cover parental support and adjusting (“overriding”) the CRR proposed by the models / scorecards.
  • LGD (Loss Given Default) is being calculated based on parameters for collateral based upon differing recovery rates and seniority of unsecured exposures.
  • EaD is being calculated based on total limit sanctioned to a customer, with the conservative view that the client may fully draw down its facilities.
  • The credit application process will be standardised using the CARM system and will contain the CRR and information on estimated LGD% and EaD. Credit applications will continue to contain both the FG and CRR (and LGD) of the client during a transition phase.
  • The credit application process has been standardised using the CARM system and contains the CRR and information on estimated LGD% and EaD. Credit applications will continue to contain both the FG and CRR (and LGD) of the client during a transition phase.

 Customer Impacts

The main impacts will be

• The IRBA will allow HSBC to follow risk-based pricing strategy, whereby exposure to less risky clients will command lower capital charge, resulting in lower pricing for the less risky customers.

• Beneficiaries of this risk-based pricing strategy will be

  1.   Sovereigns in emerging markets
  2.  OECD Banks rated AAA or AA Non-OECD Bank rated A- or better
  3.   NBFIs with higher ratings
  4.   Corporate customers rated better than BBB. A good proxy is that Fair Default Risk i.e. grade 4.2 on the CRR for an unsecured credit equals c. 100% RWA.
  5.   Non-rated corporate customer will also benefit from the internal rating of PD.

• A downgrade and rapidly deteriorating credit quality will result in steeply increased RWA value unless offsetting collateral is arranged. Thus pricing for poorly performing clients will increase.

• Undrawn committed facilities (Liquidity + Overdrafts) although usually granted to a customer with a very low PD (and even for less than 365 days) will attract capital. This is due to the minimum effective maturity of 1 year.

• Long dated facilities will attract higher capital (Although for RWA% Basel II caps the maturity factor at 5 years).

• An increased range of collateral will be eligible to mitigate exposures to optimise LGD.

Further preparations required by HSBC Bangladesh:

As part of the group requirement, HSBC Bangladesh has already taken the necessary steps to start reporting under IRB Advanced Approach of Basel II from 2009. It is expected that they will be well poised to adopt IRBA by 2008.

However, as the Bangladesh Bank decision to adopt Standardized Approach for the banks in Bangladesh has come only recently, preparations are yet to be made to meet the local reporting requirement also. Since under the Standardized Approach, most of the credit risk assessment responsibilities fall on the ECAI, adoption of the following steps by HSBC Bangladesh should be sufficient to ensure their compliance with the requirement of Bangladesh Bank.

  1. They should appoint the most competent ECAI to carry out credit ratings on behalf of their customers. The ECAI must have sufficient resources (both manpower and necessary knowledge of probability statistics, financial econometrics, times series analysis and market condition) to carry out high quality credit assessments. The ECAI should be able to perform independently in a fair manner and should not be subject to political or economic pressures that may influence the rating.
  2. They should thoroughly review the credit ratings carried out to ensure that there are no rating biases. High default culture in the financial market of Bangladesh indicates that existing weak regulatory framework for rating agencies may influence borrowers’ behavior to obtain good rating inappropriately.
  3. The reduced Standardised charges on retail lending could make such lending more attractive to banks. However, such exposure continues to be risky in the perspective of Bangladesh. HSBC should ensure that they hold an appropriate amount of capital to cover the heightened risk exposure from increased retail lending.


Globally Basel II accord will have significant impact in improving banks’ capital adequacy position and their internal mechanism and supervisory process. It will be beneficial to the commercial banks, as it requires review and measurement of different types of risk, which ultimately have effect on risk management approach to comply with the accord standards. Once implemented, banks would also be benefited with significant improvements in their risk management systems, business models, capital strategies and disclosure standards as well as overall efficiency. The idea of the new framework is to strengthen risk-based requirements by laying out principles for banks to assess the adequacy of their capital. It will also enable the supervisors to review such assessments to make sure that banks have adequate capital to support their risks.

The new Basel accord has been prepared on the basis of three pillars: minimum capital requirement, supervisory review process and market discipline. Three types of risks — credit risk, market risk and operational risk — have to be considered under the minimum capital requirement. For credit risk measurement, new framework provides two different methods – standardized approach and internal ratings-based approach. Implementation of standardized approach requires credit assessment intuitions or rating agencies for determining capital requirements of the banks in line with the Basel fixed risk-weight. On the other hand, internal rating based approach allows banks to rate their credit risks, which again have two different approaches — foundation approach and advanced approach.

HSBC Bangladesh will have to adopt the standardized approach for local regulatory requirement (as set out by Bangladesh Bank) while it will also adopt the IRB – Advanced Approach in line with group decision. Its capital adequacy position is not likely to be of any immediate concern under both the scenario, as HSBC Bangladesh is already very well capitalized (RCAR of 25% in 2005, as opposed to Basel II requirement of 8%). However, opportunities presented under Basel II (in the form of risk based pricing strategy, acceptance of different types of collateral, implementation of stringent credit risk assessment process etc should be utilized.

HSBC Bangladesh has already implemented most of the required steps for IRB Advanced Approach, and will be able to complete the whole process by 2008, ahead of the implementation deadline of 1st January 2009, as set out by the Group. It is also not likely to face any significant problem in the implementation of Standardized Approach, as most of the preparatory steps for Standardized Approach fall on the regulator and the ECAIs, and not on banks.