Overview of Basel II Accord

The Basel Committee on Banking Supervision (BCBS) released the revised capital accord, also called, Basel II, on June 26, 2004. The document is called “International Convergence of Capital Measurement and Capital Standards: A Revised Framework”.

The significant features of Basel II are:

• Significantly more risk sensitive capital requirements and takes into account operational risk of banks apart from credit and market risks. It also provides for risk treatment based on securitization.

• Great use of assessment of risk provided by banks’ internal systems as inputs to capital calculations.

• Provides a range of options for determining the capital requirements for credit risk and operational risk to allow banks and national regulators to select the approaches that are most suitable for them.

• Capital requirement under the new accord is the minimum. It has a provision for supplementary capital that can be adopted by national regulators.

• The Accord promotes strong risk management practices by providing capital incentives for banks having better risk management practices.

One most note that the capital requirements under basel II do not include liquidity risk, interest rate risk of banking book, strategic risk, and business risk. These risks would fall under “Supervisory Review Process”. If supervisors feel that the capital held by a bank is not sufficient, they could require the bank to reduce its risk or increase its capital or both. With respect to interest rate risk on banking book, the Accord puts in place a criteria for “Outliers”. Where a bank under 200 basis points interest rate shock faces reduction in capital by 20% or more, such banks would be outliers.

The Basel Accord is based on three pillars:

1. Minimum Capital Requirements
2. Supervisory Review Process
3. Market Discipline

Pillar I – Minimum Capital Requirements

Pillar I provides details of how banks must calculate their minimum capital requirements. It suggests various approaches for calculating capital for credit, market, and operational risk.

Capital for Credit Risk

• Standardized Approach
• Internal Ratings Based (IRB) Foundation Approach
• Internal Ratings Based (IRB) Advanced Approach

Capital for Market Risk

• Standardized Approach (Maturity Method)
• Standardized Approach (Duration Method)
• Internal Models Method

Capital for Operational Risk

• Basic Indicator Approach
• Standardized Approach
• Advanced Measurement Approach

Pillar 2 – Supervisory Review Process

The Pillar II concerns the supervisory approach to bank capital management. The objective here is to ensure that banks follow rigorous procedures, measure their risk exposures correctly, and have enough capital to cover their risks.

• Evaluate risk assessment
• Ensure soundness and integrity of bank’ internal process to assess the adequacy of capital
• Ensure maintenance of minimum capital – with PCA for shortfall
• Prescribe differential capital, where necessary, i.e., where the internal processes are slack.

Pillar 3 – Market Discipline

Pillar III introduces requirements for banks to disclose their risk information to the financial markets, in the hope that investors will be better able to exert discipline on bank behavior.

• Enhance Disclosure
• Core disclosures and supplementary disclosures
• Timely – semi annual