These notes are prepared for Islamic banking students to provide a short brief about the Basel Accord.

1. Spring of knowledge andvirtue
Zanzibar University
IBF 8403 RISK MANAGEMENT IN
ISLAMIC BANKING
TOPIC THREE: The three Pillars of Basel II
Accord
Mr. Ramadhani

2. INTRODUCTION
• The Basel Accord is a set of international banking regulations
that aim to promote stability in the global financial system.
• These regulations were established by the Basel Committee on
Banking Supervision (BCBS).

3. Background
• The Basel Accord was first introduced in 1988 as Basel I, in
response to the need for international standards to assess and
mitigate banking risks.
• It was revised and updated over the years, leading to the
introduction of Basel II in 2004 and Basel III in 2010.
• The accord primarily focuses on capital adequacy and risk
management for banks.

4. Basel I
• Basel I aimed to establish minimum capital requirements for
banks based on the level of credit risk they faced.
• It introduced the concept of risk-weighted assets (RWA) to
determine the amount of capital banks needed to hold.
• The accord classified assets into broad risk categories and
assigned risk weights to each category.

5. Limitations of Basel I
• Despite its importance, Basel I had several limitations, such as:
Oversimplified risk-weighting system
• Limited focus on operational and market risks
• Inadequate coverage of off-balance sheet activities

6. Basel II
• Basel II was introduced to address the shortcomings of Basel I
and to provide a more comprehensive framework for risk
management.
• It introduced three pillars to strengthen the banking system:
• Minimum capital requirements
• Supervisory review process
• Market discipline

7. Pillar 1: Minimum Capital Requirements
• Basel II refined the risk-weighting system introduced by Basel I.
• It categorized credit risk into several classes with more precise
risk weights.
• Operational risk and market risk were also given more
prominence.

8. Pillar 2: Supervisory Review Process
• Basel II emphasized the need for effective supervisory oversight
and risk management by banks.
• Banks were required to develop their internal risk assessment
processes and demonstrate adequate capital adequacy.
• Supervisors were responsible for reviewing and assessing
banks' risk management systems.

9. Pillar 3: Market Discipline
• Basel II encouraged banks to enhance their disclosure and
transparency practices.
• Banks were required to disclose information related to their risk
profile, capital adequacy, and risk management strategies.
• Market participants could use this information to make informed
investment decisions.

10. Limitations of Basel II and Introduction to
Basel III
• Basel II, though an improvement, still had limitations:
• Inadequate coverage of liquidity risk
• Insufficient focus on leverage and interconnectedness
• Basel III was introduced in response to the financial crisis of
2008 to further strengthen the global banking system.

11. Basel III
• Basel III expanded the regulatory framework to address the
limitations of Basel II.
• It introduced new measures to enhance the quality and quantity
of capital, manage liquidity risks, and address systemic risks.
• Some key components of Basel III include:
• Common Equity Tier 1 (CET1) capital requirements
• Capital conservation buffer
• Liquidity coverage ratio (LCR)
• Net stable funding ratio (NSFR)

12. Benefits of Basel III
• Basel III aims to:
• Improve the resilience of the banking sector
• Enhance risk management practices
• Increase the overall stability of the global financial system

13. Basel II Accord: Enhancing
Risk Management in Banking

14. Introduction
• Basel II is an international banking regulation framework
developed by the Basel Committee on Banking Supervision
(BCBS) to strengthen risk management practices in the banking
industry.
• This presentation will provide an in-depth understanding of the
key components and objectives of Basel II.

15. Background
• Basel II was introduced in 2004 as a revision of the original
Basel Accord (Basel I) to address its limitations and strengthen
the global banking system.
• It aimed to provide a more comprehensive framework for risk
management and capital adequacy.

16. Objectives of Basel II
• Enhance risk sensitivity: Basel II aimed to better align capital
requirements with the underlying risks faced by banks, thus
promoting a more risk-sensitive approach.
• Strengthen risk management: The framework aimed to
encourage banks to improve their risk management practices
and processes.
• Promote international consistency: Basel II aimed to establish a
common international standard for banking regulations,
fostering consistency and comparability across countries.

17. Three Pillars of Basel II
• Basel II comprises three key pillars, each addressing a specific
aspect of risk management and capital adequacy:
• Minimum Capital Requirements
• Supervisory Review Process
• Market Discipline

18. Pillar 1: Minimum Capital Requirements
• Pillar 1 focuses on determining the minimum capital requirements
based on the risks faced by banks.
• It introduced three types of risk: credit risk, operational risk, and
market risk.
• Credit risk: Basel II introduced the concept of internal ratings-based
(IRB) approaches, allowing banks to use their internal models to
determine credit risk capital requirements.
• Operational risk: It provided standardized approaches and advanced
measurement approaches (AMA) for calculating operational risk
capital.
• Market risk: Basel II refined the calculation of capital for market risk,
including interest rate risk, equity risk, and foreign exchange risk.

19. Pillar 2: Supervisory Review Process
• Pillar 2 focuses on the role of supervisors in assessing banks'
risk management processes and determining whether their
capital is adequate.
• It encourages banks to develop their internal risk assessment
processes and demonstrate effective risk management
practices.
• Supervisors are responsible for conducting regular reviews of
banks' risk profiles and assessing the adequacy of their capital.

20. Pillar 3: Market Discipline
• Pillar 3 promotes market discipline and transparency by
requiring banks to disclose information about their risk profile,
capital adequacy, and risk management practices.
• The aim is to provide stakeholders with sufficient information to
make informed investment and risk assessment decisions.
• Disclosures cover areas such as risk exposure, risk mitigation
techniques, and capital composition.

21. Benefits of Basel II
• Improved risk sensitivity: The framework ensures that capital
requirements are aligned with the actual risks faced by banks,
leading to a more accurate measurement of risk.
• Enhanced risk management: Basel II encourages banks to
adopt robust risk management practices, thereby reducing the
likelihood of financial crises.
• Greater transparency: Market discipline and increased
disclosures improve transparency, enabling stakeholders to
make more informed decisions.
• International consistency: Basel II promotes consistency and
comparability in banking regulations across different
jurisdictions.

22. Challenges and Criticisms
• Complexity: The framework is complex and requires substantial
resources for implementation, especially for smaller banks.
• Pro-cyclicality: Some argue that Basel II's risk-sensitive
approach can amplify economic cycles and contribute to
financial instability during downturns.
• Model reliance: Basel II relies on banks' internal models for risk
measurement, which can introduce variability and subjectivity.

23. Basel II Implementation and Impact
• Basel II was implemented gradually in different jurisdictions, with
some countries adopting it more extensively than others.
• The framework significantly influenced risk management practices in
the banking industry, leading to improvements in risk measurement,
capital allocation, and governance.
• The Basel II Accord represents a significant advancement in risk
management and capital adequacy standards for banks.
• It introduced a more comprehensive framework, aligning capital
requirements with underlying risks and promoting international
consistency.
• Basel II played a crucial role in enhancing risk management
practices and transparency in the global banking system.

24. Next Lecture We’ll Look On
Calculation From This Basel II
InShaAllah.

25. THANKS FOR Ur ATTns