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

Susan McKiernan
Biography
email Susan
+44 (0) 141 249 5425

John Salmon
Biography
email John
+44 (0) 141 248 4858

See: Basel II documents (at BIS.org)