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Evolution of Basel II and Its Implementation in Bangladesh
Banks are financial institutions that raise funds by accepting deposits for the purpose of
investment and lending. Deposits may be term, demand and/or savings. All of these deposits
represent borrowing on part of the banker. These are bank liabilities. Banks use these funds to
earn profit by making loan and investment. As banks are using the depositors’ deposits to earn
profit they incur substantial risk. That is the uncertainty of getting back the loan made along with
interest and the investment. People must have confidence in the banking system otherwise they
will not be induced to deposit. Banking system must ensure the safety of the fund of depositors
so as to obtain confidence of people. Banks must use their funds based on principles of Safety,
Liquidity and Profitability.
To ensure the safety of deposits regulators require banks to maintain their equity capital. Capital
provided by banks act as cushion against uncertainty. Risk is unavoidable while conducting
banking business. Risks may be Credit, Operational and/or Market risk. But it is known that
higher the risk higher the expected return. If banks operate on the basis of deposits of general
people they will be induced to take higher risk as they themselves will not incur any loss. But
this will be terrible and disastrous for the whole financial sectors and the economy. To reduce the
risk to the depositors the necessity arises for maintaining minimum equity capital.
To ensure that banks maintain minimum capital and take proper measurement to guard other
risks there must be some standards and guidelines. These guidelines limit the amount of risk
exposure by banks. Standards for maintaining consistency of minimum capital so that proper risk
is assessed, evaluated and measured that will be used to determine risk weighted assets.
In 1988 Basel accords/principles have been determined by Basel Committee on Banking
Supervision that defines minimum capital maintenance against loans, advances and investments.
These guidelines are known as Basel I. Assets of banks were to credit risk, carrying risk weights
of zero ten, twenty, fifty, and up to one hundred. Banks with international presence are required
to hold capital equal to 8% of the risk-weighted assets. Basel I was effective in Bangladesh till
2008, December. Basel I was not more risk absorbent and sensitive to more risks arising out of
complex financial activities. It was able to handle minimum capital requirement and to handle
credit risk but was not sensitive to operational and market risk that are also greatest source of
risk. This accord did not give due recognition to the credit risk mitigation techniques and does
not recognize the role collateral can play in reducing the losses on account of credit risk. Risks
involved with new investment securities or new investment options that are highly risky were not
taken into consideration in Basel I accords.
For the banking system to be more risk sensitive all the risks arising out of credit risk,
operational risk and market risk must be taken into consideration. And also for the banks to be
aware of risks arising out of complex financial scenario and risky investment activities there
must be some proper guidelines. In response of these above necessities Basel II was developed
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so that banking institutions can be more risk absorbent. On June 26, 2004, the Basel Committee
on Banking Supervision (BCBS) released the document "International Convergence of Capital
Measurement and Capital Standards: A Revised Framework", which was supplemented in
November 2005 by an update of the Market Risk Amendment. This document, popularly known
as "Basel II Framework", offers a new set of international standards for establishing minimum
capital requirements for the banking organizations. It capitalizes on the modern risk management
techniques and seeks to establish a more risk-responsive linkage between the banks' operations
and their capital requirements. It also provides a strong incentive to banks for improving their
risk management systems. The risk sensitiveness is achieved through the three mutually
Basel II is the second of the Basel Accord which are recommendations on banking laws and
regulations issued by the Basel Committee on Banking Supervision.
Basel II, initially published in June 2004, was intended to create an international standard for
banking regulators to control how much capital banks need to put aside to guard against the types
of financial and operational risks banks (and the whole economy) face. One focus was to
maintain sufficient consistency of regulations so that this does not become a source of
competitive inequality amongst internationally active banks. Advocates of Basel II believed that
such an international standard could help protect the international financial system from the
problems that might arise if a major bank or series of banks collapse. In theory, Basel II
attempted to accomplish this by setting up risk and capital management requirements designed to
ensure that a bank has adequate capital for the risk the bank exposes itself to through its lending
and investment practices. Generally speaking, these rules mean that the greater risk to which the
bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its
solvency and overall economic stability.
Basel II aims at
1. Ensuring that capital allocation is more risk sensitive;
2. Enhance disclosure requirements which will allow market participants to assess the
capital adequacy of an institution;
3. Ensuring that credit risk, operational risk and market risk are quantified based on data
and formal techniques;
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The accord in operation
Basel II uses a "three pillars" concept – (1) minimum capital requirement, (2) supervisory review
and (3) market discipline
The first pillar- Minimum
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, Advanced IRB and Internal
Rating Based Approach. IRB stands for "Internal
For Operational risk, there are three different approaches – Basic Indicator Approach or BIA,
Standardized Approach or STA and the Advanced Measurement Approach or AMA.
For Market risk the preferred approach is VaR (Value at Risk).
As the Basel II recommendations are phased in by the banking industry it will move from
standardized requirements to more refined and specific requirements that have been developed
for each risk category by each individual bank. The upside for banks that do develop their own
modified risk measurement systems is that they will be rewarded with potentially lower risk
The second pillar- Supervisory Review
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 a framework for
dealing with all the other risks a bank may face, such as systemic risk, pension risk,
concentration risk, strategic risk, reputational risk, liquidity risk and legal risk, which the accord
combines under the title of residual risk. It gives banks a power to review their risk management
It is the Internal Capital Adequacy Assessment Process (ICAAP) that is the result of Pillar II of
Basel II accords
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Outline of the Basel II
Credit Risk Market Risk Operational Risk
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The third pillar- Market Discipline
This 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.
Market discipline, as involves sharing information, facilitates assessment of the bank by others,
including investors, analysts, customers, other banks, and rating agencies, which leads to good
corporate governance. The aim of Pillar 3 is to 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.
When market participants have a sufficient understanding of a bank's activities and the controls it
has in place to manage its exposures, they are better able to distinguish between banking
organizations so that they can reward those that manage their risks prudently and penalize those
that do not.
Basel III (or the Third Basel Accord) is a global regulatory standard on bank capital adequacy,
stress testing and market liquidity risk. The third installment of the Basel Accords was developed
in response to the deficiencies in
financial regulation revealed by
the late-2000s financial crisis.
Basel III strengthens bank capital
requirements and introduces new
regulatory requirements on bank
liquidity and bank leverage.
In addition, Basel III introduces a
minimum leverage ratio and two
required liquidity ratios. The
leverage ratio is calculated by
dividing Tier 1 capital by the
bank's risk weighted average total
consolidated assets; the banks are
expected to maintain the leverage
ratio in excess of 3%. The
Liquidity Coverage Ratio requires
a bank to hold sufficient high-
quality liquid assets to cover its
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total net cash outflows over 30 days; the Net Stable Funding Ratio requires the available amount
of stable funding to exceed the required amount of stable funding over a one-year period of
Net Stable Funding Ratio: Net stable fund includes customer deposits, long term inter-banking
lending and equity. It excludes short term inter-banking lending.
Long term assets or "structural term assets" means:
100% of loans longer than one year;
85% of loans to retail clients with a remaining life shorter than one year;
50% of loans to corporate clients with a remaining life shorter than one year;
And 20% of government and corporate bonds.
off-balance sheet categories are also weighted
Stable funding/weighted long term assets must be > 100%
The quality, consistency, and transparency of the capital base will be raised.
Tier 1 capital: the predominant form of Tier 1 capital must be common
shares and retained earnings.
Tier 2 capital instruments will be harmonized
Tier 3 capital will be eliminated.
The risk coverage of the capital framework will be strengthened.
Promote more integrated management of market and counterparty credit risk
Add the CVA (credit valuation adjustment)-risk due to deterioration in
counterparty's credit rating
Raise the capital buffers backing these exposures that can be used during time
period of stress.
Provide incentives to strengthen the risk management of counterparty credit
A leverage ratio to put a floor under the increase of leverage in the banking sector
Fourth, the Committee is introducing a series of measures to promote the increase of
capital buffers in good times that can be drawn upon in periods of stress.
Conducting stress test to reveal any probable change in economic scenario that can lead
to recession so that banks can maintain sufficient capital as buffer to use during
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Reviewing the need for additional capital, liquidity or other supervisory measures to
reduce the externalities created by systemically important institutions.
Opportunities and Challenges
Basel III is an evolution of Basel II to make banks more and more risk sensitive and shock
absorbent. It provides opportunity to banks to maintain adequate capital against possible
economic and financial risk. It enables bank to provide more risk adjusted service to its
customers. Basel III focuses on enhanced capital requirement and leverage ratio and two
liquidity ratio. It enables banks to maintain sufficient liquidity as lack of liquidity causes damage
to banks by raising inter-bank rate.
It is also challenging to the bankers as it requires more complex regulatory requirement to be
followed by banks. More capital is to be put aside from investment. It may be harmful for
developing economy which is not so much prone to financial derivative securities as they were
responsible for financial crisis in late 2000. Proper fund may not go to the growing sectors and
the economy may suffer from decline in GDP by .05-1%.
But above all as it a standard approach toward risk response arising from financial and economic
risk it should be followed by banks steadily so that they do not suffer from any competitive
disadvantage and from global economic shock that affect the individual developing economy like
ours’. Besides Basel III the liquidity requirement of Basel III should be maintained that protects
banks from any substantial fall in liquidity in the banking sectors. Again the stable fund ratio can
be applicable to some extent as it requires stable fund ratio to be certain percentage of weighted
assets over the last period. Banks in Bangladesh has also recently suffered from liquidity crisis.
So liquidity requirement of Basel III could be helpful for our banking sector though enhanced
capital requirement may cause problem as the tier 1 need to be denominated by equity and
From the overall discussion we found that Basel committee makes different standards and
strategy guidelines for the banking system depending on the situation to minimize different risks
that a Bank faces. While operating the banking operation, Bank may face liquidity crisis, credit
risks, and interest rate risks. So considering all of these Basel has emerged with these guidelines
that are followed by different banks. Though Basel has made the banking system less risky and
standard still there are some risks and infrastructural problems for which may be Basel will
emerge with new strategies and guidelines. Banks in Bangladesh has also recently suffered from
liquidity crisis. So liquidity requirement of Basel III could be helpful for our banking sector
though enhanced capital requirement may cause problem as the tier 1 need to be denominated by
equity and retained earnings.