Basel II Implementation as a Statutory Requirement of Bangladesh Bank: A Study on Bangladesh Development Bank Limited Internship Report on “Basel II Implementation as a Statutory Requirement of Bangladesh Bank: A Study on Bangladesh Development Bank Limited”
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Basel II Implementation as a Statutory Requirement of Bangladesh Bank: A Study on
Bangladesh Development Bank Limited
Internship Report on
“Basel II Implementation as a Statutory
Requirement of Bangladesh Bank: A Study
on Bangladesh Development Bank Limited”
Basel II Implementation as a Statutory Requirement of Bangladesh Bank: A Study on
Bangladesh Development Bank Limited
Prepared By:
Kazi Khairul Kabir
ID NO. 15050 (BBA), 271 (MBA)
MBA 15th Batch, Section C
Department of Accounting & Information Systems
University of Dhaka
Supervised By:
Amirus Salat
Associate Professor
Department of Accounting & Information Systems
University of Dhaka
Date of Submission: 6th July, 2014
Basel II Implementation as a Statutory Requirement of Bangladesh Bank: A Study on
Bangladesh Development Bank Limited
i
Letter of Transmittal 6th July, 2014
Amirus Salat
Associate Professor
Department of Accounting & Information Systems
University of Dhaka
Subject: Submission of internship report
Dear Sir,
It is a great pleasure for me to submit the report on ― ‘Basel II Implementation as a Statutory
Requirement of Bangladesh Bank: A Study on Bangladesh Development Bank Limited’. I am
submitting this report as part of my internship in Bangladesh Development Bank Limited. The
purpose of the report is based on my working experience in Bangladesh Development Bank
Limited and how the bank has implemented the Basel Accords following the guidelines of
Bangladesh Bank.
I believe the knowledge and experience I gathered during the internship period will be extremely
helpful in my future professional life. I will be grateful to you if you accept the report.
Thanking you.
Sincerely,
___________________
Kazi Khairul Kabir
ID: 271 (MBA)
Basel II Implementation as a Statutory Requirement of Bangladesh Bank: A Study on
Bangladesh Development Bank Limited
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Acknowledgement
First of all, I would like to convey my cordial thanks for almighty Allah whose uniqueness,
oneness, and wholeness are unchallenged to guide us in difficult circumstances. All respects are
for his holy prophet Hazrat Muhammad (SM) Peace be upon him, who enable us to recognize
the oneness my creator.
I would like to thank Amirus Salat, my university supervisor, for guiding me in planning and
composing the report. He was always available to provide me with his supervision and guidance
during the entire course. Therefore, I express colossal appreciation for his aid.
I am very grateful to Professor Santi Narayan Ghosh, Chairman Bangladesh Development
Bank Limited, for managing the internship for me and directing me by giving his valuable advice.
I also express my gratitude to Syed Md. Nazrul Islam, Deputy General Manager of Risk
Management Department, for teaching me the critical issues of Basel II.
My most heartfelt gratitude goes to all the employees of Bangladesh Development Bank Limited,
Head office and Kawran Bazar Branch, for making it a good practical and learning experience.
From the early hours of the morning to the sunset of the evening they have guided me through
various operations of the bank and provided me with essential support for my internship report.
I pray to Allah that He be merciful to all of these people.
Last but not the least thanks goes to my parents for bearing the tension, frustration and all the
hard work along with me through the entire BBA program.
Basel II Implementation as a Statutory Requirement of Bangladesh Bank: A Study on
Bangladesh Development Bank Limited
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Executive Summery This internship report is based on the three months long internship program that I have
successfully completed in Bangladesh Development Bank Limited under five distinct
departments from April 1, 2014 to June 30, 2014. As a course requirement of MBA program of
the department of Accounting & Information Systems I prepare the report. Although, I worked
in five departments of BDBL, my focal point was the compliance issue regarding Basel II of Risk
management department.
I mainly worked in risk management department which is the responsible wing for implementing
Basel II in BDBL. My faculty advisor and Deputy General Manager of Risk Management
Department helped me choose the topic- “Basel II Implementation as a Statutory Requirement of
Bangladesh Bank: A Study on Bangladesh Development Bank Limited”.
The internship report is mainly divided into two segments. In the very first portion, all the
necessary calculations related with the regulatory requirements of Basel II are calculated (such
as- Capital Adequacy Ratio, Tire 1 Capital, Tire 2 Capital, Tire 3 Capital and Risk Management
Mechanisms). In the later portion, a checklist is prepared to show the compliance issue of Basel
II and a comparison is made between the regulatory compliance reported by BDBL and Sonali
Bank Limited. It is seen that although BDBL complies all the requirements but SBL does not
conform to some of the major requirements of Basel II.
Basel II is a complex yet very important international requirement for banks. The value of the
knowledge attracted me the most. Bangladesh Bank is the governing body of all the commercial
banks in this country. To be in line with the international standard for regulation of banking
industry (Basel Accord), BB has introduced Risk Based Capital Adequacy guideline relating to
Basel II. All banks have to follow this guideline and report to BB effective from 1st January,
2010. The guidelines are structured in three aspects or pillars: (1) banks should have minimum
capital to guard against different kinds of risks (credit, market and operation risk); (2) assessing
capital adequacy with risk profile of the bank and capital growth plan and (3) public disclosure
of bank’s position on risk, capital and management.
The three main risks that a commercial bank faces are: Credit risk, Market risk and Operational
risk. Credit risk is the risk that arises from the probability that the borrowers of the bank will not
pay back. Market risk is the risk that puts the bank in adverse situation when interest rate, foreign
Basel II Implementation as a Statutory Requirement of Bangladesh Bank: A Study on
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iv
exchange or equity price move in unfavorable direction. Operational risk stems from the internal
environment, occurring when internal processes, people or system fail. The banks can become
resilient and fend off these risks with adequate capital. This is where the regulatory guidelines
come to play.
BB categorizes capital into three tiers. Tier 1 Capital, also known as the Core Capital, which are
the top quality capital for the bank. The Components include: Paid up capital, general and
statutory reserves, retained earnings, minority interest, non-cumulative preference shares, etc.
Tier 2 Capital, also known as supplementary capital, supports Tier 1 capital. Components
include: general provision; revaluation reserves for Fixed Assets, Securities and equity
investments; other preference shares and subordinated debt. Tier 3 Capital, also known as
additional supplementary capital, whose components include: short term subordinated debt to
solely guard against market risk. There are more specific guidelines for eligibility of the capital
tiers. To measure adequacy; Capital Adequacy Ratio (CAR) is calculated with Risk Weighted
Asset (RWA) on the basis of credit, market and operational risk.
Banks have to follow the regulatory rules; otherwise BB can impose penalty and/or punishment
as per Bank Company Act of 1991.
Bangladesh Development Bank Limited fulfilled all major requirements of Basel II in the three
consecutive years starting from 2010. It has been maintaining a CAR ratio of above 10%
requirement for the last three years of the compliance. In June 2012 Basel II report to BB,
recorded CAR ratio of 27.26% on actual capital. According to the same report, it has a total
eligible capital of nearly BDT 11,025 million and a Total RWA of nearly BDT 40576 million
whose 10% must be kept as capital, i.e. BDT 4057 million. Thus BDBL has a surplus of capital.
Most of its Tier 1 capital is covered by paid up capital which is high quality and major part of its
Tier 2 capital consists of subordinated debt. BDBL can smoothly implement all the pillars of
Basel II further if the impediments are removed. Data and reporting should be centralized;
reasonable time should be given for report submission, unnecessary complex measures can be
neglected to help banks adopt Basel II.
Basel II Implementation as a Statutory Requirement of Bangladesh Bank: A Study on
Bangladesh Development Bank Limited
Table of Contents Letter of Transmittal ...................................................................................................................... i
Acknowledgement ........................................................................................................................ ii
Executive Summery ..................................................................................................................... iii
B Market Risk (Capital charges for Market Risk*10)** XXXXX
C Operational Risk (Capital charge for Operational
Risk*10)**
XXXXX
Total RWA (A+B+C) XXXXX
** Capital charge for market risk and operational risk are multiplied by 10(reciprocal of minimum
capital adequacy ratio of 10%)
As per Bangladesh Bank’s guidelines RWA for Credit Risk includes both On Balance Sheet and
Off-Balance Sheet exposures. The RWA is again subdivided under Banking Book and Trading
Book. For calculating Capital Charge on Market Risk, Trading Book outstanding is used.
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4.7 Capital Charge against Credit Risk Basel II allows three ways to calculate credit risk and any one can be followed. Three approaches
are available for the firms. The Choose of an option is dependable upon the condition of the
particular bank.
1. Standard Approach (SA): It calls for the use of external credit rating by External Credit
Assessment Institutions (ECAIs). The ECAI determined risk weights for counterparty will
be used in credit risk calculation. ECAIs will also determine similar counterparty groups
and apply standard risk weightings to those categories.
2. Internal Ratings Based (IRB): This approach allows banks to use their internal assessment
of counterparty regarding the Probability of Default (PD) but requires them to use standard
supervisory parameters regarding Exposure at Default (EAD) and Loss Given Default
(LGD).
3. IRB Advanced approach: This approach allows banks to use their own internal assessment
in determining PD and quantifying EAD and LGD. Bangladesh Bank has mapped its risk
grading (ranging from 1 to 6, where 1 is the highest grading) with that of recognized ECAIs.
Where an exposure is secured by guarantee or eligible financial collateral, it may reduce
its capital charge by taking benefit of the risk mitigation described in the guidelines of
Bangladesh Bank. However, in the absence of credit rating the Risk Weight against loans
and advances would be 125 percent.
4.8 Capital Charge against Market Risk Market risk is the possibility of losses of assets in balance sheet and off-balance sheet positions
arising out of volatility in market variables i.e., interest rate, exchange rate and price. Allocation
of capital is required in respect of the exposure to risks deriving from changes in interest rates and
equity prices in the bank’s trading book, in respect of exposure to risks deriving from changes in
foreign exchange rates and commodity price in the overall banking activity. The total capital
requirement for banks against their market risk shall be the sum of capital charges against. I. Interest rate risk
II. Equity position risk
III. Foreign exchange (including gold) position risk throughout the bank’s balance sheet.
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Measurement Methodology
As banks in Bangladesh are now in a stage of developing risk management models, Bangladesh
Bank suggested the banks for using Standardized Approach for credit risk capital requirement for
banking book and Standardized (rule based) Approach for market risk capital charge in their
trading book. Maturity Method has been prescribed by Bangladesh Bank in determining capital
against market risk. In Standardized (rule based) Approach the capital requirement for various
market risks (interest rate risk, price, and foreign exchange risk) is determined separately. The total
capital requirement in respect of market risk is the sum of capital requirement calculated for each
of these market risk sub-categories. e.g.
a) Capital Charge for Interest Rate Risk = Capital Charge for Specific Risk + Capital Charge
for General Market Risk
b) Capital Charge for Equity Position Risk = Capital Charge for Specific Risk + Capital
Charge for General Market Risk
c) Capital Charge for Foreign Exchange Risk = Capital Charge for General Market Risk
d) Capital Charge for Commodity Position Risk = Capital Charge for General Market Risk
The methodology to calculate capital requirement under Standardized (rule based) Approach for
each of these market risk categories is as follows:
Capital charges for Specific risk
Capital charge for specific risk against interest related instruments is designed to protect against
an adverse movement in the price of an individual security owing to factors related to the individual
issuer.
Capital charge for General Market risk
The capital requirement for general market risk is designed to capture the risk of loss arising from
changes in market interest rates.
Capital Charges for Equity Position Risk
I. As with debt securities, the minimum capital standard for equities is expressed in terms of
two separately calculated charges the “specific risk” and the “general market risk” for the
holdings.
II. The capital charge, for both specific risk and the general market risk charge will be 10
percent.
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Capital Charges for Foreign Exchange Risk
The capital charge for foreign exchange risk will be 10 percent of bank’s overall foreign exchange
exposure. The overall foreign exchange exposure is measured by aggregating the sum of the net
short positions or the sum of net long positions; whichever is the greater, regardless of sign. The
capital charge will be 10 percent of the overall net open position.
4.9 Capital Charge against Operational Risk Operational Risk is defined as the risk of losses resulting from inadequate or failed internal
processes, people and systems or from external events. This definition includes legal risk, but
excludes strategic and reputation risk.
Measurement Methodology
Banks operating in Bangladesh shall compute the capital requirements for operational risk under
the Basic Indicator Approach (BIA). Under BIA, the capital charge for operational risk is a fixed
percentage, denoted by · (alpha) of average positive annual gross income of the bank over the past
three years. Figures for any year in which annual gross income is negative or zero, should be
excluded from both the numerator and denominator when calculating the average. The capital
charge may be expressed as follows:
K = [(GI 1 + GI2 + GI3)*α]/n
Where,
K = the capital charge under the Basic Indicator Approach
GI = only positive annual gross income over the previous three years (i.e., negative or zero gross
income if any shall be excluded)
α = 15 percent (as per guideline)
n = number of the previous three years for which gross income is positive.
Total Profit/Loss before tax XX
(+) Total Provision XX
(+) Total Operating Expenses XX
(-) Realized profit/losses from sale of securities XX
(-) Extra ordinary/irregular items XX
(-) Income derived from insurance XX
= Gross Income (GI) XXXX
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4.10 Pillar-II Supervisory Review Process The main theme of Pillar 2 is that,
1. Banks have to have a process, a Risk Management Unit (RMU), to assess their own
risk profile and calculate adequate capital
2. They must have a strategy to maintain the level of adequate capital required in the
future.
Banks should also have Supervisory Review Process (SRP) team which will manage all the risks
a bank faces, develop and implement better risk management techniques.
4.11 Internal Capital Adequacy Assessment Process (ICAAP) The supervisory process is a tool for the regulators to ensure adequate capital of banks to guard
against risks. It also delegates responsibility to top management of the institutions to make certain
of the implementation of the laws. The management must analyze their risks internally, make plan
on capital and maintain proper internal control process. Supervisory review process will address:
1. Risk that are not covered by Pillar-I (risks other than credit, market and operation)
2. External risk factors to the bank that are not captured by Pillar-I
Management must take steps to plan for achieving proper capital target and to gradually use
advance process of calculating RWA and CAR. The five main features of effective review process
are:
1. Board and senior management oversight
2. Sound capital assessment
3. Comprehensive assessment of risks
4. Monitoring and reporting
5. Internal control review
The SRP team is responsible for making and applying Internal Capital Adequacy Assessment
Process (ICAAP). The ICAAP is an important part of Pillar 2 because it helps the bank in risk
measurement and capital planning process. It is basically an internally created guideline regarding
risk assessment and reporting process to be followed when considering the amount and type of
capital the bank should maintain to support its business.
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4.12 Supervisory Review Evaluation Process (SREP) BB Basel II implementation cell reviews each bank’s supervisory review process. This cell
evaluates the bank’s SRP and then arranges dialogue/ discussion session with that bank’s SRP
team. BB SREP team will analyze bank’s review process. BB expects banks to operate above
minimum capital standards. BB, through SREP, will intervene at an early stage if they feel that the
bank would falter in meeting minimum capital requirement. The frequency of meeting will depend
on bank’s activities and the difference between capital requirement assessed by the bank and BB
team. Usually, the SRP-SREP Dialogue takes place in BB once every year.
4.13 Stress Testing Stress testing is a kind of sensitivity analysis or “what-if-analysis” for banks. The purpose of this
test program is to find out how shock absorbent a bank is. Basically, the test calls for changing a
single variable at a time and observing what the result bring to the bank’s assets, profitability,
liquidity and other measures. The variables are changed to test forward looking scenario a bank
might face. This will measure the vulnerability and exposure to rare, exceptional but potential
events.
The five different risk factors that are used in stress testing are:
1. Interest rate
2. Forced sale value of collateral
3. Non-performing loan (NPL)
4. Share price
5. Foreign exchange rate
Stress test on liquidity must be done separately. The three levels of shocks are: Minor (e.g. only
1% change in interest rate), Moderate (e.g. a 3% change in interest rate) and Major (e.g. 5% or
more change in interest rate).
After BB collects information from banks and finishes the dialogue, the bank and BB will set the
total capital requirement for the bank corresponding to the risks they face. The general format of
additional capital is given below:
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Particulars of risks against which capital required Required Capital
Credit Risk XX
Market Risk XX
Operational Risk XX
A) Capital Requirement against Credit, Market & Operational
risks
XXXX
Residual risk XX
Evaluation of Core Risk management XX
Credit concentration risk XX
Interest rate risk in the banking book XX
Liquidity risk XX
Reputation risk XX
Settlement risk XX
Strategic risk XX
Environmental & Climate change risk XX
Other material risk XX
B) Requirement of additional capital under SRP XXXX
Total Capital Requirement (A+B) for the year XXXXX
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4.14 Pillar 3 Market Discipline This pillar is present in Basel II framework to complement the other two pillars. This pillar requires
the bank to disclose information to public and be more transparent to the financial market and the
participants. Current and potential stockholders, depositors and borrowers will want to know the
bank’s strengths and potential loss of assets.
Disclosure Requirements
Banks must have a formal disclosure framework approved by the Board or CEO of the bank.
The banks must follow the disclosure format provided by BB.
The disclosed information must be consistent to the audited financial statements. The information
must be material and omission of important and relevant data must be avoided. Banks have to
submit the data along with annual financial statements to BB by the end of March every year.
Banks can disclose the Basel II information in their Annual Report and/or on their website. In case
of Annual Report, a separate section must be utilized to report information. In case of website, the
Basel II information must be provided in the home-page. The historical information must be
maintained in the website for 4 years. The components must be disclosed in tabular form and in
quantitative and/or in qualitative form regarding the topics mentioned below:
1. Scope of application
2. Capital structure
3. Capital adequacy
4. Credit Risk
5. Equities: disclosures for banking book positions
6. Interest rate risk in the banking book (IRRBB)
7. Market risk
8. Operational risk
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Chapter 5:
Mechanisms for Measuring Credit,
Market and Operational Risk
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5.1 Bangladesh Bank guideline regarding Basel-II To cope with the international best practice and to make the bank’s capital more risk sensitive
quantitative and qualitative information are prepared by banks based on the audited financial
position of the Bank under the revised Risk Based Capital Adequacy Guideline (RBCA)
introduced by the central Bank of Bangladesh. Banking Supervision’s (BCBS) capital framework
was published in 1988. Capital Maintenance requirement based on risk weighted assets was set
up. Banks operating in Bangladesh have been maintaining these provisions in line with the Basel
Committee. Bangladesh Bank issued Basel-II guidelines for all scheduled banks on ‘Risk Based
Capital Adequacy (RBCA)’ to report their capital requirements which came fully into effect since
January 01, 2010, in December 2008. It is actually subsequent supplements/revisions replacing
the previous rules under Basel-I. The guidelines have been devised to make the regulatory
requirements more appropriate and also to assist the banks to follow the instructions more
efficiently for smooth implementation of the Basel II framework in the banking sector. The major
highlights of the Bangladesh Bank regulations in this regards are:
To maintain capital adequacy ratio (CAR) at a minimum of 10% (9% for 2010) of Risk
Weighted Assets.
To adopt the Standardized Approach for credit risk for implementing Basel II.
To adopt Standardized (Rule Based) Approach for market risk.
To adopt Basic Indicator Approach for operational risk.
To submit the returns to Bangladesh Bank on a quarterly basis.
5.2 Credit Risk
Credit risk refers to the risk that a borrower will default on any type of debt by failing to make
payments which it is obligated to do. The risk is primarily that of the lender and includes lost
principal and interest, disruption to cash flows, and increased collection costs. Credit default risk,
Concentration risk, Country risk are different types of Credit risk. The loss from credit risk may
be complete or partial and can arise in a number of circumstances. For example: