The Agency would expect the banks to provide further comments, and suggestions to this Draft Document. These comments and others relevant pronouncements would be incorporated in SAMA’s final Detailed Guidance Document.

Credit risk

SAMA proposes to make available the IRB and Standardized Approaches. SAMA anticipates, however, that while majority of banks incorporated in Saudi Arabia would initially implement the Standardized Approach, foreign joint venture banks and other Saudi banks would eventually implement the FIRB and eventually AIRB approaches.

Banks planning to implement the Foundation IRB: SAMA expects banks to develop historical data and to create internal rating systems that will permit them to use the Foundation IRB approach.

Banks planning to implement the Advanced IRB: Some banks may wish to develop data and systems to implement Advanced IRB Approach. Such plans will be encouraged and the IRB models to be used will be agreed with SAMA on a case-by-case basis.

Branches of Foreign Banks

A branch of a foreign bank may be permitted to use its parent’s IRB methodology subject to SAMA’s approval. SAMA’s approval process would consider, among other things, the implementing strategies, options and procedures of home supervisory authorities and the appropriateness, for the Saudi marketplace, of the data and experience used to calculate the branch IRB capital requirements.

Operational Risk

SAMA proposes to permit banks operating in Saudi Arabia to implement any one of the following four approaches for measuring operational risk: the Basic Indicator Approach, the Standardized Approach, the Alternative Standardized Approach and the Advanced Measurement Approach.

Market Risk

Bank should continue to apply SAMA’s circular No. BCS 355 of Dec. 29,2004.

Banks operating in Saudi Arabia must have sound, effective and complete strategies and processes to assess and maintain on an ongoing basis the internal capital that they consider adequate to cover their risks. They must perform regular internal reviews of these strategies and processes to ensure that they are proportionate to the nature, scale and complexity of their activities.

SAMA will review and evaluate the risks to which the banks are or might be exposed. Based upon these reviews and evaluations it will determine whether such arrangements and capital levels ensure sound management and coverage of the risks. SAMA will establish the frequency and intensity of these reviews and evaluations, taking into account systemic importance, nature, scale and complexity of banks. It will annually update these reviews and evaluations.

SAMA requires that all subsidiaries and significant minority interest in insurance entities at 10% or more are to be excluded from banks capital at 50% from Tier-I, and 50% from Tier-II capital.

In addition, SAMA would not permit the recognition of surplus capital of an insurance subsidiary for the capital adequacy of the group.

(Refer to Paragraph 33 of International Convergence of Capital Measurement and Capital Standards – June 2006)

SAMA will ensure that majority-owned or controlled insurance subsidiaries, which are not consolidated and for which capital investments are deducted, are themselves adequately capitalized to reduce the possibility of future potential losses to the bank. SAMA, through the parent banks 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.

(Refer to Paragraph 34 of International Convergence of Capital Measurement and Capital Standards – June 2006)

Banks planning to implement the IRB approaches may seek a longer time frame than 1^st January 2008. This plans will be approved by SAMA on a case-by-case basis.

[258] “The new Basel framework requires a Banks to produce a formal Bank rollout plan or proposals to implement Basel II for review and approval by the supervisor for the IRB approval. The rollout plan would set out a detailed proposal for implementation of the IRB approaches, specifying to what extent and when it intends to roll out IRB approaches across all significant asset classes and business units over time”.

Banks will continue to use Basel 1 up to the time they are ready to implement Basel II.

Banks using the IRB approach to credit risk and any of the permitted operational risk approaches would be expected to submit capital calculations that are compliant with the new Basel framework.

Claims on sovereigns and their central banks will be risk weighted as follows;

“Under the Standardized Approach, the applicable risk weight for claims on sovereigns is based on the rating assigned to the sovereign by a recognized external credit assessment institution (ECAI) such as a rating agency. A national supervisory authority may apply a lower risk weight to its banks’ exposures to their own sovereign when the exposures are denominated in the local currency and funded in the local currency. Other national supervisory authorities may also permit their banks to apply the same risk weight to domestic currency exposures to this sovereign. In these instances, there is no trans-border risk”.

SAMA requires that banks operating in Saudi Arabia, with exposures to other sovereigns meeting the above criteria, to use the preferential risk weight assigned to the sovereign by the relevant national supervisory authority.

“Risk weights for claims on sovereigns can also be determined using the country risk scores assigned by Export Credit Agencies (ECAs).

SAMA will not allow the use of ECAs’ of other countries to provide credit rating for sovereigns.

The new Basel framework allows national supervisory authorities to implement one of two options for risk-weighting claims on banks and securities firms.

Option-1:

Under option 1, the risk weight is one category less favorable than that assigned to claims on the Sovereign of the country of incorporation. However, for claims on Banks in countries with sovereign rated BB+ to B- and on banks in unrated countries the risk weight will be capped at 100%.

Option-2:

Under option 2, the risk weight is based on the external rating a bank by a recognized ECAI.

SAMA requires banks operating in Saudi Arabia to use Option 2

National supervisory authorities, who choose to allow preferential treatment for claims on sovereigns may also allow preferential treatment for certain short term claims on banks. To be eligible for this treatment, these exposures must be denominated and funded in the local currency and have an original maturity of three months or less. These exposures may receive a risk weight that is one category less favourable than that assigned to claims on the Sovereign, subject to a floor of 20 percent. However, this preferential treatment is not available for banks risk weighted at 150%.

SAMA will allow banks to adopt the preferential treatment option

A “0” risk weight may be given to those MDB’s that meet qualifying criteria under Basel-II. Alternatively, MDBS will be risk weighted in accordance with their individual ratings as per banks option 2 without any preferential treatments for short-term exposures.

SAMA intends to adopt a 0% risk weight for qualifying MDB’s and in general the risk weights to be determined on the basis of individual MDB rating as for option # 2 for banks.

SAMA proposes to continue with the current definition of PSEs as specified in its Capital Adequacy Requirements (CAR) guidelines in ERMs-Q-14.

The new Basel framework allows claims on (PSEs) to be risk weighted using either option 1 or option 2 for claims on Banks.

SAMA requires banks operating in Saudi Arabia to use Option -2.

Under the new Basel framework, the risk weight for corporate exposures is determined using the rating assigned by a recognized ECAI’s. However, national supervisory authorities may allow banks to use the 100 percent risk weight for all corporate exposures in lieu of using external ratings.

SAMA requires the risk weight for all corporate exposures to be in accordance with their external ratings. Unrated corporate exposures to be at 100%.

There are qualifying requirement based on product type, and the size of the exposure itself. These exposure include loans to individuals, leases, small business facilities, or car loans and other consumer loans, etc. In specific the new Basel framework attaches small business facilities enterprises (SBFE) qualifying criteria for claims that may be treated as retail claims for regulatory capital purposes and included in a regulatory retail portfolio. These criteria include a granularity criterion, which requires that the portfolio be sufficiently diversified to reduce the risk to a level warranting the 75 percent risk weight.

Specifically, with respect to exposure size, national supervisory authorities have the option of setting a numerical limits on the amount of gross exposure before taking into account credit risk mitigation to one counterparty¹. For example, this limit could be set at 0.2 percent of the total retail portfolio as proposed in the framework.

To meet the 75% RW criteria SAMA requires the non-mortgage retail portfolio claims to meet the above criteria and should not exceed SR. 5 million.

National supervisory authorities should evaluate whether the risk weights in Para 69 are considered to be too low based on default experience for these types of exposures in their jurisdictions. Supervisors therefore may require higher weights. SAMA does not require higher risk weights for such exposures.

¹ Aggregate exposure means gross amount subject to the above conditions in para

“The new Basel framework allows claims secured by residential mortgages to receive a risk weight of 35 percent. Investments in hotel properties and time-share properties would be excluded from the definition of residential mortgage property. However, this reduced risk weight would only be applicable if there is a substantial security margin. Further, the loan default experience should also be considered”.

SAMA will continue to apply a 100 percent retail risk weight to such claims and continue to monitor the default experience of this asset class for future consideration.

“Under the new Basel framework, mortgages on commercial real estate are risk weighted at 100 percent. However, national supervisory authorities may apply a preferential risk weight of 50 percent to parts of commercial real estate loans under exceptional circumstances”.

SAMA will continue to apply 100% risk weight.

“The new Basel framework proposes the following subject to national discretion.

SAMA requires the above treatment with exception if the level of provisioning is more than 50%; the RW is reduced to 50%. In such cases the RW will be at 100%.

¹ On outstanding loans balance

Other Assets

The standard risk weight for all other assets will be 100%.

At national discretion, gold bullion held in own vaults or on an allocated basis to the extent backed by bullion, liabilities can be treated as cash and therefore risk- weighted at 0%.

SAMA requires that the treatment of gold bullion to be equivalent to cash.

Off-balance-sheet items under the Standardized Approach will be converted into credit exposure equivalents through the use of credit conversion factors (CCF).

Commitments with an original maturity of up to one year and commitments with an original maturity over one year will receive a CCF of 20% and 50%, respectively. However, any commitments that are unconditionally cancelable at any time by the bank without prior notice, or that effectively provide for automatic cancellation due to deterioration in a borrower’s creditworthiness, will receive a 0% CCF.

For short-term self-liquidating trade letters of credit arising from the movement of goods (e.g. documentary credits collateralized by the underlying shipment), a 20% CCF will be applied to both issuing and confirming banks.

Where there is an undertaking to provide a commitment on an off-balance sheet item, banks are to apply the lower of the two applicable CCFs.

CCFs not specified above remain as defined in the 1988 Accord.

The credit equivalent amount of OTC derivatives and SFTs that expose a bank to counterparty credit risk is to be calculated under the rules set forth in Annex 4 of International Convergence of Capital Measurement and Capital Standards, 2006.

(Refer to Paragraph 87 of International Convergence of Capital Measurement and Capital Standards – June 2006).

With regard to unsettled securities, commodities, and foreign exchange transaction, SAMA requires that bank’s prepares its Prudential return submission based on trade date rather than settlement date as per the accounting convention. Banks are encouraged to develop, implement and improve systems for tracking and monitoring the credit risk exposure arising from unsettled transactions as appropriate for producing management information that facilitates action on a timely basis. Furthermore, when such transactions are not processed through a delivery-versus-payment (DvP) or payment-versus-payment (PvP) mechanism, banks must calculate a capital charge as set forth in Annex 3 of International Convergence of Capital Measurement and Capital Standards – June 2006

(Refer to Paragraph 89 of International Convergence of Capital Measurement and Capital Standards – June 2006)

As a general rule, Banks should use solicited ratings from eligible ECAIs. However, the new Basel framework allows national supervisory authorities to permit the use of unsolicited ratings.

SAMA will not allow Banks to use unsolicited ratings.

Calculation of expected losses

A bank must sum the EL amount (defined as EL multiplied by EAD) associated with its exposures (excluding the EL amount associated with equity exposures under the PD/LGD approach and securitization exposures) to obtain a total EL amount. While the EL amount associated with equity exposures subject to the PD/LGD approach is excluded from the total EL amount, paragraphs 376 and 386, International Convergence of Capital Measurement and Capital Standards – June 2006 apply to such exposures. The treatment of EL for securitization exposures is described in paragraph 563, International Convergence of Capital Measurement and Capital Standards – June 2006.

(Refer para 375, International Convergence of Capital Measurement and Capital Standards – June 2006)

For off-balance sheet items, exposure is calculated as the committed but undrawn amount multiplied by a CCF. There are two approaches for the estimation of CCFs: a foundation approach and an advanced approach.

EAD under the foundation approach

The types of instruments and the CCFs applied to them are the same as those in the standardized approach, with the exception of commitments, Note Issuance Facilities (NIFs) and Revolving Underwriting Facilities (RUFs).

A CCF of 75% will be applied to commitments, NIFs and RUFs regardless of the maturity of the underlying facility. This does not apply to those facilities which are uncommitted, that are unconditionally cancellable, or that effectively provide for automatic cancellation, for the example due to deterioration in a borrower’s creditworthiness, at any time by the bank without prior notice. A CCF of 0% will be applied to these facilities.

The amount to which the CCF is applied is the lower of the value of the unused committed credit line, and the value that reflects any possible constraining availability of the facility, such as the existence of a ceiling on the potential lending amount which is related to a borrower’s reported cash flow. If the facility is constrained in this way, the bank must have sufficient line monitoring and management procedures to support this treatment.

In order to apply a 0% CCF for unconditionally and immediately cancellable corporate overdrafts and other facilities, banks must demonstrate that they actively monitor the financial condition of the borrower, and that their internal control systems are such that they could cancel the facility upon evidence of a deterioration in the credit quality of the borrower.

Where a commitment is obtained on another off-balance sheet exposure, banks under the foundation approach are to apply the lower of the applicable CCFs.

EAD under the advanced approach

Banks which meet the minimum requirements for use of their own estimates of EAD, will be allowed to use their own internal estimates of CCFs across different product types provided the exposure is not subject to a CCF of 100% in the foundation approach.

¹ There are no transition arrangements for the Advanced IRB Approach and the Market based Approach to qualify.

Assumptions and calculations

Current Accord

Basel II

Calculation of Floor

¹Banks should categories banking book exposures into different asset classes (i.e. corporate, bank, sovereign, retail and equity exposures, as well as assets under securitisation), subject to definitions set out in paragraphs 215-243, 273 and 538-542 of the ―International Convergence of Capital Measurement and Capital Standards : A Revised Framework" issued by the Basel Committee on Banking Supervision in June 2004.
²RWAs should be calculated based on the Current Basel Capital Accord
³ Missing
⁴In the case of banks that are branch of foreign banking groups, all or part of their IRB systems may be centrally developed by the parent bank and monitored on a group basis.
⁵For the purpose of this table, an internal rating system is regarded as ready for SAMA's recognition if the bank considers that it meets all the minimum qualifying criteria set out the Implementation Plan of the ―Basel II‖ in Saudi Arabia‖ issued by SAMA in May 2005.

Background

¹ Due to correlation between defaults in a portfolio, observed default rates can systematically exceed the critical PD values if these are determined under the assumption of independence of the default events.