BASEL II NORMSMANAGEMENT OF FINANCIALINSTITUTUIONSBYRasmi Ranjan Mishra
BASEL ACCORDS Refers to banking supervision Accords(recommendations on banking laws andregulations), Basel I and Basel II issuedby the Basel Committee on BankingSupervision(BCBS). Called the Basel Accords as the BCBSmaintains its secretariat at the Bank ofInternational Settlements in Basel,Switzerland
Background Under capital requirements rules, credit institutionslike banks must at all times maintain minimumfinancial capital, to cover the risks Aim - to ensure financial soundness of suchinstitutions, maintain customer confidence in thesolvency of the institutions, ensure stability offinancial system at large, and protect depositorsagainst losses. Basel Committee on Banking Supervisionestablished in 1974 to provide a forum for bankingsupervisory matters. Members are from Belgium,Canada, France, Germany, Italy, Japan, Luxembourg,the Netherlands, Spain, Sweden, Switzerland, UKand USA.
Background Basel Committee not a formal regulatoryauthority, but has great influence over supervisingauthorities in many countries. Committee hopes to achieve common approachesand common standards across membercountries, without detailed harmonisation of eachmember countrys supervisory techniques. In 1988, recognising the emergence of larger moreglobal financial services companies, the Committeeintroduced Basel Capital Accord (Basel I) tostrengthen soundness and stability of internationalbanking system by requiring higher capital ratios.
Background Since 1988, the framework of Basel I progressivelyintroduced not only in member countries but also invirtually all other countries with active internationalbanks. In June 1999, proposal issued for a new CapitalAdequacy framework to replace Basel I. After extensive communication with banks andindustry groups, the revised framework, Basel IIissued in 2004. Basel II has been or will be implemented byregulators in most jurisdictions but with varyingtimelines and may be restricted methodologies.
BASEL II The second of the Basel Accords. Purpose is to create an international standard that bankingregulators can use when creating regulations about capital banksto be put aside to guard against financial and operational risks An international standard can help protect the internationalfinancial system from possible problems should a major bank or aseries of banks collapse. Basel II attempts to accomplish this by setting up rigorous risk andcapital management requirements to ensure that a bank holdscapital reserves appropriate to the risk the bank exposes itself tothrough lending and investment practices. Greater the risk greater the amount of capital bank needs to hold tosafeguard its solvency and overall economic stability.
FINAL OBJECTIVE Ensuring that capital allocation is more risksensitive Separating operational risk from credit risk,and quantifying both Attempting to align economic andregulatory capital more closely to reducescope for regulatory arbitrage
Why BASEL II Basel I Accord succeeded in raising total level ofequity capital in the system. However, it also pushed unintended consequences. Since it does not differentiate risks very well, itperversely encouraged risk seeking. All loans givento corporate borrowers were subject to the samecapital requirement, without taking into accountability of the counterparties to repay. It ignored credit rating, credit history, riskmanagement and corporate governance structure ofall corporate borrowers. All were treated as privatecorporations. It also promoted loan securitization that led to theunwinding in the subprime market.
Why BASEL II Basel II much more risk sensitive, as it is aligning capitalrequirements to risks of loss. Better risk management in a bankmeans bank may be able to allocate less regulatory capital. The objective of Basel II is to modernise existing capitalrequirements framework to make it more comprehensive andrisk sensitive. The Basel II framework therefore designed to be more sensitiveto the real risks that firms face than Basel I. Apart from looking at financial figures, it also considersoperational risks, such as risk of systems breaking down orpeople doing the wrong things, and also market risk.
•Pillar 1 sets out the minimum capital requirements firms will berequired to meet to cover credit, market and operational risk.•Pillar 2 sets out a new supervisory review process. Requiresfinancial institutions to have their own internal processes to assesstheir overall capital adequacy in relation to their risk profile.•Pillar 3 cements Pillars 1 and 2 and is designed to improve marketdiscipline by requiring firms to publish certain details of theirrisks, capital and risk management as to how senior managementand the Board assess and will manage the institutions risks.Three Pillars of Basel II Framework
Pillar 1 : Minimum capital requirementsInstitutions total regulatory capital must be atleast 8% (ratio same as in Basel I) of its riskweighted assets, based on measures of THREERISKS
Measure of RisksMeasuring credit risk Banks can assess risk using three different ways of varyingdegree of sophistication– Standardised approach– Foundation IRB(Internal Rating-Based Approach)– Advanced IRB Standardised approach sets out specific risk weights forcertain types of credit risk, e.g. 0% for short term governmentbonds, 20% for exposures to OECD Banks, 50% for residentialmortgages and 100% weighting on unsecured commercialloans(as in BASEL I) A new 150% rating comes in for borrowers with poor creditratings Minimum capital requirement (the percentage of risk weightedassets to be held as capital) remains at 8%. Banks adopt standardised ratings approach will be forced torely on the ratings generated by external agencies. CertainBanks are developing the IRB approach as a result.
Measure of RisksMeasuring operational risk Operational risk is risk of loss resulting frominadequate or failed internal processes,people and systems or from externalevents. It includes legal risk, such asexposure to fines, penalties and privatesettlements. It does not, however, includestrategic or reputational risk. Three methods to measure operational risk– Basic Indicator Approach– Standardised Approach– Advanced Measurement Approach
Measure of RisksMeasuring market risk Institutions may be obliged to make a series ofdisclosures about their risk profiles and regulatorycapital procedures available to market participants,while balancing between meaningful disclosures andneed to protect confidential and proprietaryinformation. Preferred approach is VaR( Value atRisk) As the Basel 2 recommendations are phased in bythe banking industry it will move from standardisedrequirements to more refined and specificrequirements that have been developed for each riskcategory by each individual bank
Pillar 2 : Supervisory Review Covers Supervisory Review Process, describing principles foreffective supervision. Supervisors obliged to evaluate activities, corporategovernance, risk management and risk profiles of banks todetermine whether they have to change or to allocate morecapital for their risks (called Pillar 2 capital) Deals with regulatory response to the first pillar, givingregulators much improved tools over those available to themunder Basel I Also provides framework for dealing with all the other risks abank may face, such as Systemic risk, pension risk,concentration risk, strategic risk, reputation risk, liquidity riskand legal risk, which the accord combines under the title ofresidual risk It gives banks a power to review their risk managementsystem.
Pillar 3 : Market Discipline Covers transparency and the obligation ofbanks to disclose meaningful informationto all stakeholders Clients and shareholders should havesufficient understanding of activities ofbanks, and the way they manage theirrisks
Implementation progress Implementation has to accommodate differing cultures, varyingstructural models, and complexities of public policy andexisting regulation. Corporate strategy will be implementedbased in part on how Basel II is ultimately interpreted byvarious countries legislatures and regulators. The USA’s various regulators have agreed on a final approach.They have required the Internal Ratings-Based approach for thelargest banks, and the standardized approach will not beavailable to anyone. In India, RBI implemented Basel II standardized norms on 31stMarch 2009 and is moving to internal ratings in credit and AMAnorms for operational risks in banks. EU has already implemented the Accord via the EU CapitalRequirements Directives. Many European banks already reportcapital adequacy ratios according to the new system. All creditinstitutions adopted it by 2008.
CONCLUSION Basel II Framework lays down a more comprehensivemeasure and minimum standard for capital adequacy Seeks to improve on existing rules by aligning regulatorycapital requirements more closely to underlying risks thatbanks face. In addition, it intends to promote a more forward-lookingapproach to capital supervision, that encourages banks toidentify the present and future risks, and develop orimprove their ability to manage them. Hence intended to be more flexible and better able toevolve with advances in markets and risk managementpractices. Basel II Accord attempts to fix glaring problems with theoriginal accord. It does this by more accurately definingrisk, but at the cost of considerable rule complexity