BASEL-2 NORMS

ByV.Chaitanya Lakshmi

BASEL ACCORDS

Refers to banking supervision Accords (recommendations on banking laws and regulations), Basel I and Basel II issued by the Basel Committee on Banking supervision(BCBS)

Called the Basel Accords as the BCBS maintains its secretariat at the Bank of International Settlements in Basel, Switzerland

INTRODUCTION

Basel Committee not a formal regulatory authority, but has great influence over supervising authorities in many countries. 

In 1988, for recognizing the emergence of larger more global financial services companies, the Committee introduced Basel Capital Accord (Basel I) to strengthen soundness and stability of international banking system by requiring higher capital ratios.

Basel Committee on Banking Supervision established in 1974 to provide a forum for banking supervisory matters. 

• Under capital requirements rules, credit institutions like banks must at all times maintain minimum financial capital, to cover the risks

• Aim - to ensure financial soundness of such institutions, maintain customer confidence in the solvency of the institutions, ensure stability of financial system at large, and protect depositors against losses

• After extensive communication with banks and industry groups, the revised framework, Basel II issued in 2004

BASEL II

The second of the Basel Accords.

Purpose is to create an international standard that banking regulators can use when creating regulations about capital banks to be put aside to guard against financial and operational risks

An international standard can help protect the international financial system from possible problems should a major bank or a series of banks collapse.

Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through lending and investment practices.

Greater the risk greater the amount of capital bank needs to hold to safeguard its solvency and overall economic stability.

OBJECTIVE

Ensuring that capital allocation is more risk sensitive

Separating operational risk from credit risk, and quantifying both

Attempting to align economic and regulatory capital more closely to reduce scope for regulatory arbitrage

WHY BASEL II

Basel I Accord succeeded in raising total level of equity capital in the system.

However, it also pushed unintended consequences. Since it does not differentiate risks very well, it perversely

encouraged risk seeking. All loans given to corporate borrowers were subject to the same capital requirement, without taking into account ability of the counterparties to repay.

It ignored credit rating, credit history, risk management and corporate governance structure of all corporate borrowers. All were treated as private corporations.

It also promoted loan securitization that led to the unwinding in the subprime market.

• Basel II much more risk sensitive, as it is aligning capital requirements to risks of loss. Better risk management in a bank means bank may be able to allocate less regulatory capital

• The objective of Basel II is to modernise existing capital requirements framework to make it more comprehensive and risk sensitive

• The Basel II framework therefore designed to be more sensitive to the real risks that firms face than Basel I

• Apart from looking at financial figures, it also considers operational risks, such as risk of systems breaking down or people doing the wrong things, and also market risk.

• Pillar 1 sets out the minimum capital requirements firms will be required

to meet to cover credit, market and operational risk

• Pillar 2 sets out a new supervisory review process.  Requires financial institutions to have their own internal processes to assess their overall capital adequacy in relation to their risk profile

• Pillar 3 cements Pillars 1 and 2 and is designed to improve market discipline by requiring firms to publish certain details of their risks, capital and risk management  as to how senior management and the Board assess and will manage the institution's risks.

3 Pillars of Basel II Framework

FIRST PILLARdeals with maintenance of regulatory capital

calculated for three major components of risk that a bank faces- credit risk, operational risk, and market risk

The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardized approach, foundation IRB and advanced IRB

For operational risk, there are three different approaches - basic indicator approach or BIA, standardized approach or TSA, and the internal measurement approach

For market risk the preferred approach is VAR i.e. value at risk

Pillar 1 : Minimum capital requirements

Institution's total regulatory capital must be at least 8% (ratio same as in Basel I) of its risk

weighted assets are based on measures of THREE RISKS

%8assets weighted-risk Total

capital ofamount the

CREDIT RISK :

The risk of loss arising from outright default due to inability or unwillingness of the customer or counter party to meet commitments in relation to lending, trading, settlement and other financial transaction of the customer or counter party to meet commitments

MARKET RISK :

The possibility of loss caused by changes in the market variables such as interest rate, foreign exchange rate, equity price and commodity price

OPERATIONAL RISK :

Operational risk is risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.  It includes legal risk, such as exposure to fines, penalties and private settlements.  It does not, however, include strategic or reputational risk.

SECOND PILLARdeals with the regulatory response to the first

pillarprovides a framework for dealing with all the

other risks a bank may face, such as systemic risk, pension risk, concentrated risk, strategic risk, reputational risk, liquidity risk and legal risk

gives banks a power to review their risk management system

Internal Capital Adequacy Assessment Process (ICAAP) is the result of Pillar II of Basel II accords

THIRD PILLAR

aims to complement the minimum capital requirements and supervisory review process by developing a set of disclosure requirements which will allow the market participants to gauge the capital adequacy of an institution

allow market discipline to operate by requiring institutions to disclose details on the scope of application, capital, risk exposures, risk assessment processes and the capital adequacy of the institution

 It must be consistent with how the senior management including the board assess and manage the risks of the institution

CONCLUSION Basel II Framework lays down a more comprehensive

measure and minimum standard for capital adequacy

Seeks to improve on existing rules by aligning regulatory capital requirements more closely to underlying risks that banks face.

In addition, it intends to promote a more forward-looking approach to capital supervision, that encourages banks to identify the present and future risks, and develop or improve their ability to manage them.

Hence intended to be more flexible and better able to evolve with advances in markets and risk management practices.

Basel II Accord attempts to fix glaring problems with the original accord. It does this by more accurately defining risk, but at the cost of considerable rule complexity