Basel II: an introduction to the new Capital Adequacy
Rules
This guide is based on an international agreement. It was
last updated in September 2008.
Background
Capital requirements rules state that credit institutions, like
banks and building societies, must at all times maintain a minimum
amount of financial capital, in order to cover the risks to which
they are exposed. The aim is to ensure the financial
soundness of such institutions, to maintain customer confidence in
the solvency of the institutions, to ensure the stability of the
financial system at large, and to protect depositors against
losses.
The Basel Committee on Banking Supervision was established in
1974 to provide a forum for banking supervisory matters. It
is made up of senior officials responsible for banking supervision
or financial stability issues in central banks and other
authorities in charge of the prudential supervision of banking
businesses. Members of the Basel Committee come from Belgium,
Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands,
Spain, Sweden, Switzerland, the UK and the US.
Although the Basel Committee is not a formal regulatory
authority in itself, it has great influence over the supervising
authorities in many countries. The hope is that by agreeing
basic goals, the Committee can achieve common approaches and common
standards across many member countries, without attempting detailed
harmonisation of each member country's supervisory techniques.
In 1988, recognising the emergence of larger more global
financial services companies, the Committee introduced the Basel
Capital Accord (Basel I). This sought to strengthen the
soundness and stability of the international banking system by
requiring higher capital ratios.
Since 1988, the framework contained in Basel I has been
progressively introduced not only in member countries but also in
virtually all other countries with active international
banks. In June 1999, the Committee issued a proposal for a
new Capital Adequacy framework to replace Basel I. Following
extensive communication with banks and industry groups, the revised
framework was issued in 2004. Basel II, as it is known, has
been or will be implemented by regulators in most jurisdictions but
with varying timelines and, in some instances, with some of its
methodologies being restricted. In the European Union, it is
implemented via the EU Capital Requirements Directive.
Basel II basics
The objective of Basel II is to modernise the existing capital
requirements framework to make it more comprehensive and risk
sensitive.
The Basel II framework is therefore designed to be more
sensitive to the real risks that firms face than Basel I. As
well as looking at financial figures, such as how much money the
firm controls, it also considers operational risks, such as the
risk of systems breaking down or people doing the wrong things, and
also market risk.
The Basel II framework consists of three "pillars":-
- Pillar 1 sets out the minimum capital requirements firms will
be required to meet to cover credit, market and operational
risk.
- Pillar 2 sets out a new supervisory review process. This
requires financial institutions to have their own internal
processes to assess their overall capital adequacy in relation to
their risk profile. These are subject to review and
evaluation by their supervisors.
- Pillar 3 cements Pillars 1 and 2 and is designed to improve
market discipline by requiring firms to publish certain details of
their risks, capital and risk management. The intention is
that these disclosures should be in line with how senior management
and the Board assess and manage the institution's risks.
This paper outlines the rules on minimum capital
requirements.
Basel II and the Capital Requirements Directive
Basel II applies to internationally active banks. As noted
above, in the European Union, the framework has been implemented
through the Capital Requirements Directive (CRD). The CRD
affects certain types of investment firms and all deposit takers
(including banks and building societies), except credit unions.
The framework under the CRD reflects the flexible structure and
the major components of Basel II. It has been based on the
three "pillars", but has been tailored to the specific features of
the EU market.
In the UK, the new capital adequacy framework has been
implemented by the Financial Services Authority (FSA) and detailed
rules are contained in its Handbook.
Minimum capital requirements
Basel II requires that an institution's total regulatory capital
must be at least 8% of its risk weighted assets, based on measures
of its credit risk, market risk and operational risk. This
ratio is unchanged from Basel I.
Measuring credit risk
In relation to credit risk, Basel II permits banks to use one of
two methodologies. They can assess risk using the
"Standardised" Approach, which involves external credit
assessments, or they can use their own internal systems for rating
credit risk. The standardised approach is similar to Basel I
but risk weights are based on credit ratings provided by external
credit assessment institutions such as rating agencies. In
contrast, the foundation and advanced internal ratings based
approaches reflect the fact that many internationally active banks
already have in place extremely sophisticated internal methods for
modelling, assessing and managing risk. These latter methods
can be used only with the explicit approval of the institution's
supervisor.
Measuring operational risk
One of the key changes in Basel II is the addition of an
operational risk measurement to the calculation of minimum capital
requirements. This has also been included in the CRD.
Operational risk is defined as the risk of loss resulting from
inadequate or failed internal processes, people and systems or from
external events. This definition includes legal risk, such as
exposure to fines, penalties and private settlements. It does
not, however, include strategic or reputational risk.
In calculating operational risk capital charges, Basel II sets
out three different methods which may be adopted.
The Basic Indicator Approach is the simplest of
the three approaches, and will be the default option for most
firms. It applies a calculation based on the firm's income to
determine its capital requirements.
The Standardised Approach (not to be confused
with the approach for credit risk of the same name) again relies on
calculations based on income, but with different percentages
applying across different business lines. To be able to take
advantage of the Standardised Approach, firms will have to meet
certain qualifying criteria.
The Advanced Measurement Approach is the most
advanced of the three options. Under this approach, each firm
calculates it own capital requirements, by developing and applying
its own internal risk measurement system. As with the
Standardised Approach, the firm must meet certain qualifying
criteria, and the risk measurement system must be validated by the
FSA before it will be allowed to take advantage of the AMA.
Calculating market risk
As with credit and operational risk, Basel II is designed to
reflect the increasingly sophisticated risk management practices
that exist in many financial institutions by offering them the
opportunity to use advanced internal models for calculating market
risk. The aim is to encourage institutions to monitor and
control risk effectively, by obliging them to make a series of
disclosures about their risk profiles and regulatory capital
procedures which are available to market participants. The
intention is that they strike a balance between meaningful
disclosures and the need to protect confidential and proprietary
information.
Conclusion
Undoubtedly, Basel II introduces a vastly more sophisticated and
risk sensitive framework. There is even a school of thought
that, had Basel II been fully implemented a few years ago, at the
height of the credit "boom", the current "crunch" may have been
less severe. Nevertheless, we can expect to see increased
regulation (possibly in the form of refinements to Basel II) as
governments and regulators respond to current market turmoil.
Contacts
See: Basel II
documents (at BIS.org)
Disclaimer: We hope you find OUT-LAW’s content useful. It’s prepared by the lawyers at Pinsent Masons. Please remember, though, that it’s intended as general information only. It’s not legal advice. If that’s what you’re seeking, please
contact us. See also: our
full disclaimer