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Basel II Accord

Basel II

Bank for International SettlementsBasel Accord - Basel I

Basel II

Background

BankingMonetary policy - Central bank

Risk - Risk managementRegulatory capital

Tier 1 - Tier 2

Pillar 1: Regulatory Capital

Credit risk Standardized - F-IRB - A-IRB

PD - LGD - EADOperational risk

Basic - Standardized - AMAMarket risk

Duration - Value at risk

Pillar 2: Supervisory Review

Economic capitalLiquidity risk - Legal risk

Pillar 3: Market Disclosure

Disclosure

Business and Economics Portal

Basel II is the second of the Basel Accords , which are recommendations on banking lawsand regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II, which was initially published in June 2004, is to create an international standardthat banking regulators can use when creating regulations about how much capital banksneed to put aside to guard against the types of financial and operational risks banks face.

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Advocates of Basel II believe that such an international standard can help protect theinternational financial system from the types of problems that might arise should a major

bank or a series of banks collapse. In practice, Basel II attempts to accomplish this bysetting up rigorous risk and capital management requirements designed to ensure that a

bank holds capital reserves appropriate to the risk the bank exposes itself to through its

lending and investment practices. These rules mean that the greater risk to which thebank is exposed, the greater the amount of capital the bank needs to hold tosafeguard its solvency and overall economic stability .

The final version aims -

1. Ensuring that capital allocation is more risk sensitive;2. Separating operational risk from credit risk , and quantifying both;3. Attempting to align economic and regulatory capital more closely to reduce the

scope for regulatory arbitrage .

While the final accord has largely addressed the regulatory arbitrage issue, there are stillareas where regulatory capital requirements will diverge from the economic.

Basel II has largely left unchanged the question of how to actually define bank capital ,which diverges from accounting equity in important respects. The Basel I definition, asmodified up to the present, remains in place.

The Accord in operation

Basel II uses a "three pillars" concept – (1) minimum capital requirements (addressingrisk), (2) supervisory review and (3) market discipline – to promote greater stability in

the financial system .The Basel I accord dealt with only parts of each of these pillars. For example: withrespect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simplemanner while market risk was an afterthought; operational risk was not dealt with at all.

The first pillar

The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk , operational risk and market risk . Other risks are not considered fully quantifiable at this stage.

The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardized approach , Foundation IRB and Advanced IRB. IRBstands for "Internal Rating-Based Approach".

For operational risk , there are three different approaches - basic indicator approach or BIA, standardized approach or TSA, and advanced measurement approach or AMA.

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For market risk the preferred approach is VaR ( value at risk ).

The second pillar-

The second pillar deals with the regulatory response to the first pillar, giving regulators

much improved 'tools' over those available to them under Basel I. It also provides aframework for dealing with all the other risks a bank may face, such as systemic risk , pension risk , concentration risk , strategic risk, reputation risk , liquidity risk and legalrisk , which the accord combines under the title of residual risk. It gives bank a power toreview their risk management system.

The third pillar-

The third pillar greatly increases the disclosures that the bank must make. This isdesigned to allow the market to have a better picture of the overall risk position of the

bank and to allow the counterparties of the bank to price and deal appropriately.

Basel II and the regulators

One of the most difficult aspects of implementing an international agreement is the needto accommodate differing cultures, varying structural models and the complexities of

public policy and existing regulation. Banks’ senior management will determinecorporate strategy, as well as the country in which to base a particular type of business,

based in part on how Basel II is ultimately interpreted by various countries' legislaturesand regulators.

To assist banks operating with multiple reporting requirements for different regulators

according to geographic location, there are several software applications available. Theseinclude capital calculation engines and extend to automated reporting solutions whichinclude the reports required under COREP /FINREP .

Basel II norms: Strength from three pillars

PILLAR I of Basel II norms provide banks with guidelines to measure the various typesof risks they face — credit, market and operational risks — and the capital required tocover these risks.

Credit risk

A bank always faces the risk that some of its borrowers may renege on their promises for timely repayments of loan, interest on loan or meet the other terms of contract. This risk is called credit risk, which varies from borrower to borrower depending on their creditquality. Basel II requires banks to accurately measure credit risk to hold sufficient capitalto cover it.

Factors affecting credit risk can be summarised by the following formula:

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Expected Loss (EL) on a loan = Exposure at default (EAD) * Loss given default (LGD) *Probability of Default (PD)

The bank can also suffer losses in excess of expected losses, say, during economicdownturns. These losses are called unexpected losses. Ideally, a bank should recover

expected loss on a loan from its customer through loan pricing. The capital base isrequired to absorb the unexpected losses, as and when they arise.

Market risk -

As part of the statutory requirement, in the form of SLR (statutory liquidity ratio), banksare required to invest in liquid assets such as cash, gold, government and other approvedsecurities. For instance, Indian banks are required to invest 25 per cent of their netdemand and term liabilities in cash, gold, government securities and other eligiblesecurities to comply with SLR requirements.Such investments are risky because of the change in their prices. This volatility in the

value of a bank's investment portfolio in known as the market risk, as it is driven by themarket. The change in the value of the portfolio can be due to changes in the interestrates, foreign exchange rates or the changes in the values of equity or commodities.

Operational risk -

Several events that are neither due to default by third party nor because of the vagariesof the market. These events are called operational risks and can be attributed to internalsystems, processes, people and external factors.

Pillar I ensures that banks measure their risks properly and maintain adequate capital to

cover them. But can Pillar I alone ensure that there are no more bank failures? No. Asany stable structure cannot stand on a single pillar, Basel II relies on the pillars of supervisory reviews and market discipline to keep the banks healthy.

Pillar II ensures that not only do the banks have adequate capital to cover their risks, butalso that they employ better risk management practices so as to minimise the risks.Capital cannot be regarded as a substitute for inadequate risk management practices.

This pillar requires that if the banks use asset securitisation and credit derivatives andwish to minimise their capital charge they need to comply with various standards andcontrols. As a part of the supervisory process, the supervisors need to ensure that the

regulations are adhered to and the internal measurement systems are standardised andvalidated.

The supervisory process is based on four principles:

Principle 1: Banks should have a process for assessing their overall capital adequacy

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vis-a-vis their risk profile and a strategy for maintaining their capital levels.

Principle 2: Supervisors should review and evaluate banks' internal capital adequacyassessments and strategies, as well as their ability to monitor and ensure compliance with

regulatory capital ratios. Supervisors should take appropriate supervisory action if theyare not satisfied with the result of this process.

Principle 3: Supervisors should expect banks to operate above the minimum regulatorycapital ratios and should have the ability to require banks to hold capital in excess of theminimum.

Principle 4: Supervisors should seek to intervene at an early stage to prevent capital fromfalling below the minimum levels required to support the risk characteristics of a

particular bank and should require rapid remedial action if capital is not maintained or restored.

Given the kind of responsibilities, the supervisor's role assumes high importance in thenew Basel II accord. Pillar II does not seek to harmonise supervisory processes acrosscountries as they have different supervisory objectives, legal processes and authority of supervisors. It allows for sufficient national discretion but still it wants supervisors tomaintain some degree of consistency in their approaches.

Market discipline -

Banking operations are becoming complex and difficult for supervisors to monitor andcontrol. Though supervisors try to inculcate corporate governance in banks, they can take

cue from the market to buttress their supervisory and monitoring activities. In thiscontext, Basel Committee has recognised that market discipline is so important that itwarrants being the third pillar of Basel II norms.This market discipline is brought through greater transparency by asking banks to makeadequate disclosures.

The potential audiences of these disclosures are supervisors, bank's customers, ratingagencies, depositors and investors.With frequent and material disclosures, outsiders can learn about the bank's risk. Armedwith this information, the outsiders can always protect themselves by ending their relationships with the bank.

Market discipline has two important components:

Market signalling in form of change in bank's share prices or change in bank's borrowing ratesResponsiveness of the bank or the supervisor to market signals

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Seeing the importance of the impact that the markets can have on banks, Pillar III provides a comprehensive menu of public and regulatory disclosures like disclosuresrelated to capital structure (core and supplementary capital), capital adequacy, risk assessment and risk management processes to enhance the transparency in bankingoperations.

What they mean for banks

BASEL II norms are expected to have far-reaching consequences on the health of financial sectors worldwide because of the increased emphasis on banks' risk-management systems, supervisory review process and market discipline.

The new norms bring to fore not only the issues of bank-wide risk measurement butalso of active risk management.

This will help in better pricing of the loans in alignment with their actual risks. The

beneficiary will be the customer with high credit-worthiness and ratings as they will beable to get cheaper loans.

Basel II norms require vast amount of historical data and advanced techniques andsoftware for calculation of risk measures. This will translate into huge demand for IT,BPO and outsourcing services.

According to estimates, cost of implementation of the new norms may range from $10million to $150 million depending on the size of the bank.

A flip side is that the knowledge acquired by the big banks due to the implementation

of complex norms would act as an entry barrier to any new competition entering intothe market, as international markets provide incentive to sovereigns and banks thathave implemented Basel II.

Small and medium sized banks will find it difficult to finance high implementation costsof the norms. If national supervisors make the norms compulsory to implement, these

banks might have no other option but to merge with other banks. Therefore, consolidationin banking industry with increased mergers and acquisitions is expected.

Higher risk sensitivity of the norms provides no incentive to lend to borrowerswith declining credit quality. During economic downturns, corporate profits and ratings

tend to decline. This can lead to banks pulling the plugs on lending to corporates withfalling credit ratings, at a time when these companies will be in desperate need of credit.

The opposite is expected during economic booms, when corporate credit worthinessimproves and banks will be more than willing to lend to corporates.

With better risk measurement practices in place the capital allocation for loans toquality borrowers are going to decrease. Banks can use this capital for other purposes to

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increase profits. But the population of rated corporate is small in India and most of themwould have to be assigned a risk weight of 100 per cent.

The benefit of lower risk weight of 20 per cent and 50 per cent would, therefore, beavailable only for loans to a few corporates. The cover required for bad loans will

increase exponentially with deteriorating credit quality, which can lead to an increase incapital requirement.