Basel II Accord

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Basel II

Bank for International Settlements
Basel Accord - Basel I
Basel II
Background

Banking
Monetary policy - Central bank
Risk - Risk management
Regulatory capital
Tier 1 - Tier 2
Pillar 1: Regulatory Capital

Credit risk
Standardized - F-IRB - A-IRB
PD - LGD - EAD
Operational risk
Basic - Standardized - AMA
Market risk
Duration - Value at risk
Pillar 2: Supervisory Review

Economic capital
Liquidity risk - Legal risk
Pillar 3: Market Disclosure

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Basel II is the second of the Basel Accords, which are recommendations on banking laws and 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 standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. Advocates of Basel II believe that such an international standard can help protect the international 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 by setting 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. 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.

The final version aims at:

  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 still areas 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, as modified up to the present, remains in place.

Contents

[edit] The Accord in operation

Basel II uses a "three pillars" concept – (1) minimum capital requirements (addressing risk), (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: with respect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market risk was an afterthought; operational risk was not dealt with at all.

[edit] 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. IRB stands for "Internal Rating-Based Approach".

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

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

[edit] 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 a framework 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 legal risk, which the accord combines under the title of residual risk.

[edit] The third pillar

The third pillar greatly increases the disclosures that the bank must make. This is designed 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.

[edit] Criticisms

The most serious criticisms of Basel II are that the consultative committee approach to rule-making will result in a "lowest common denominator" system whose capital requirements are more unstable than Basel I. Other criticisms include that the more sophisticated risk measures unfairly advantage the larger banks that are able to implement them and, from the same perspective, that the developing countries generally also do not have these banks and that Basel II will disadvantage the economically marginalized by restricting their access to credit or by making it more expensive.

The first of these is causing problems already, as the financial crisis which began in August 2007 reveals the inadequacy of current international banking rules.

The second of these is a valid point, but it is difficult to see how this can be overcome. More risk sensitive risk measures were required for the larger, more sophisticated banks and, while the less sophisticated measures are simpler to calculate, due to their lower risk sensitivity they need to be more conservative.

The third criticism has elements of truth; the better credit risks will be advantaged as banks move towards true pricing for risk. Experience with these systems in the United States and the United Kingdom, however, shows that the improved risk sensitivity means that banks are more willing to lend to higher risk borrowers, just with higher prices. Borrowers previously 'locked out' of the banking system have a chance to establish a good credit history.

Another criticism is that the operation of Basel II will lead to a more pronounced business cycle. This criticism arises because the credit models used for pillar 1 compliance typically use a one year time horizon. This would mean that, during a downturn in the business cycle, banks would need to reduce lending as their models forecast increased losses, increasing the magnitude of the downturn.

Essentially this once again gives rise the question, whether Probability of Default ("PD") and Loss Given Default ("LGD") (the first one an indicator for the probability of incurring loss, the second an indicator for the severity of loss) are really pairwise independent as the credit risk model, which Basel II is based on, does assume or if, as part of the available research data on long running US debt seems to show[who?], there are significant correlation effects to be observed. Settling this matter will stay on the agenda of researchers in the field for years to come.

Regulators should be aware of this risk and can be expected to include it in their assessment of the bank models used.

[edit] September 2005 update

On September 30, 2005, the four US Federal banking agencies (the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision) announced their revised plans for the U.S. implementation of the Basel II accord. This delays implementation of the accord for US banks by 12 months [1].

[edit] November 2005 update

On November 15, 2005, the committee released a revised version of the Accord, incorporating changes to the calculations for market risk and the treatment of double default effects. These changes had been flagged well in advance, as part of a paper released in July 2005. [2]

[edit] July 2006 update

On July 4, 2006, the committee released a comprehensive version of the Accord, incorporating the June 2004 Basel II Framework, the elements of the 1988 Accord that were not revised during the Basel II process, the 1996 Amendment to the Capital Accord to Incorporate Market Risks, and the November 2005 paper on Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework. No new elements have been introduced in this compilation. This version is now the current version. [3]

[edit] November 2007 update

On November 1, 2007, the Office of the Comptroller of the Currency (U.S. Department of the Treasury) approved a final rule implementing the advanced approaches of the Basel II Capital Accord. This rule establishes regulatory and supervisory expectations for credit risk, through the Internal Ratings Based Approach (IRB), and operational risk, through the Advanced Measurement Approach (AMA), and articulates enhanced standards for the supervisory review of capital adequacy and public disclosures for the largest U.S. banks [4].

[edit] Basel II and the regulators

One of the most difficult aspects of implementing an international agreement is the need to accommodate differing cultures, varying structural models, and the complexities of public policy and existing regulation. Banks’ senior management will determine corporate 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' legislatures and regulators.

To assist banks operating with multiple reporting requirements for different regulators according to geographic location, there are several software applications available. These include capital calculation engines and extend to automated reporting solutions which include the reports required under COREP/FINREP.

[edit] Implementation progress

Regulators in most jurisdictions around the world plan to implement the new Accord, but with widely varying timelines and use of the varying methodologies being restricted. The United States of America's various regulators have agreed on a final approach - see [5] for the Notice of Proposed Rulemaking. They have required the Internal Ratings-Based approach for the largest banks, and the standardized approach will not be available to anyone. In India, the RBI has implemented the Basel II norms.

In response to a questionnaire released by the Financial Stability Institute (FSI)[6], 95 national regulators indicated they were to implement Basel II, in some form or another, by 2015.

The European Union has already implemented the Accord via the EU Capital Requirements Directives and many European banks already report their capital adequacy ratios according to the new system. All the credit institutions will adopt it by 2008.

[edit] See also

[edit] References

[edit] External links