Basel II

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 theory, Basel II attempted to accomplish this by
setting up 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.
Objective
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.
[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.
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.
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 TSA, and the internal measurement approach (an advanced form of which is the advanced
measurement approach or AMA).
For market risk the preferred approach is VaR (value at risk).
As the Basel 2 recommendations are phased in by the banking industry it will move from standardised
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 bespoke risk measurement
systems is that they will be rewarded with potentially lower risk capital requirements. In future there will be
closer links between the concepts of economic profit and regulatory capital.
Credit Risk can be calculated by using one of three approaches:
1. Standardised Approach
2. Foundation IRB (Internal Ratings Based) Approach
3. Advanced IRB Approach
The standardised approach sets out specific risk weights for certain types of credit risk. The standard risk
weight categories are used under Basel 1 and are 0% for short term government bonds, 20% for
exposures to OECD Banks, 50% for residential mortgages and 100% weighting on unsecured commercial
loans. A new 150% rating comes in for borrowers with poor credit ratings. The minimum capital
requirement (the percentage of risk weighted assets to be held as capital) remains at 8%, with common
equity at 2% and Tier 1 cap at x% (source: Proposed basel 3 guidelines a credit positive for india)
For those Banks that decide to adopt the standardised ratings approach they will be forced to rely on the
ratings generated by external agencies. Certain Banks are developing the IRB approach as a result.
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, 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 system.
The third pillar
This pillar aims to promote greater stability in the financial system
Market discipline supplements regulation as sharing of information facilitates assessment of the bank by
others including investors, analysts, customers, other banks and rating agencies. It leads to good
corporate governance. The aim of pillar 3 is to allow market discipline to operate by requiring lenders to
publicly provide details of their risk management activities, risk rating processes and risk distributions. It
sets out the public disclosures that banks must make that lend greater insight into the adequacy of their
capitalisation. when marketplace 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
organisations so that they can reward those that manage their risks prudently and penalise those that do
not.

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Basel II

The final version aims at:

1. Ensuring that capital allocation is more risk sensitive;

[edit]The Accord in operation

The first pillar

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

Credit Risk can be calculated by using one of three approaches:

2. Foundation IRB (Internal Ratings Based) Approach

3. Advanced IRB Approach

The second pillar

This pillar aims to promote greater stability in the financial system

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