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BASEL II. Basel I. The first Basel Accord (Basel I) was completed in 1988 Set minimum capital standards for banks Standards focused on credit risk, the main risk incurred by banks Shortcomings of Basel I Capital required did not mirror a bank’s true risk profile
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Basel I The first Basel Accord (Basel I) was completed in 1988 • Set minimum capital standards for banks • Standards focused on credit risk, the main risk incurred by banks Shortcomings of Basel I • Capital required did not mirror a bank’s true risk profile • Too simple for advanced banks • Inflexible against new developments • Covers only credit and market risks • Only quantitative in nature
Basel II • Basel II is an international business standard that requires financial institutions to maintain enough cash reserves to cover risks incurred by operations. • The Basel accords are a series of recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision (BSBS). The name for the accords is derived from Basel, Switzerland, where the committee that maintains the accords meets.
Basel II The three essential requirements of Basel II are: • Mandating that capital allocations by institutional managers are more risk sensitive. • Separating credit risks from operational risks and quantifying both. • Reducing the scope or possibility of regulatory arbitrage by attempting to align the real or economic risk precisely with regulatory assessment.
Objectives of Basel II • Greater emphasis on banks’ own assessment of risk • Comprehensive framework for credit, market and operational risk • Encourages rigorous bank supervision • Ensures market transparency, disclosure • Better align regulatory capital with actual risk exposure
Minimum Capital Requirements Pillar 1 -Minimum Capital Requirements describes the calculation for regulatory capital for credit, operational and market risk. Credit risk regulatory capital requirements are more risk based than the 1988 Accord. an explicit operational risk regulatory capital charge is introduced for the first time while market risk requirements remain the same as in the Current Accord • Sets minimum acceptable capital • Capital arrived by enhanced approach with credit ratings • External or Public rating • Internal rating • Explicit treatment to operational risk
Credit risk • Borrower Data • Guarantor Data • Asset-specific Data • Default Data • Data on Recoveries • External Default Data • Data on Rating and Migration • Macro & Industry Data • Correlation Data
Market risk • Data on Exchange Rates • Data on Interest Rates • Data on Security Prices) • Data on Correlations • Data on Instruments (non-linear)
Operational Risk • Loss Event Data • Causal Data • Loss Effect • Key Risk Indicators (KRIs) • Proxies • Structured Self Assessment Data • External Data
Supervisory Review Process • Pillar 2 is intended to bridge the gap between regulatory and economic capital requirements and gives supervisors discretion to increase regulatory capital requirements if weaknesses are found in a lender's internal capital assessment process. • Banks must attain solvency relative to their risk profile • Supervisors should review each bank’s own risk assessment & capital strategies • Banks should maintain excess of minimum capital • Regulators would intervene at an early stage • Possibility of rewarding banks with better risk management systems. • RBI has already taken steps to conduct supervisory review
Market Discipline 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 Improved disclosure of • Capital structure • Risk measurement and management practices • Risk profile • Capital adequacy
Basel II and the Financial Crisis I. the average level of capital required by the new discipline is inadequate and this is one of the reasons of the recent collapse of many banks; II. the new Capital Accord, interacting with fair-value accounting, has caused remarkable losses in the portfolios of intermediaries; III. capital requirements based on the Basel II regulations are cyclical and therefore tend to reinforce business cycle fluctuations;
Basel II and the Financial Crisis IV. in the Basel II framework, the assessment of credit risk is delegated to non-banking institutions, such as rating agencies, subject to possible conflicts of interest V. the key assumption that banks’ internal models for measuring risk exposures are superior than any other has proved wrong; VI. the new Framework provides incentives to intermediaries to deconsolidate from their balance-sheets some very risky exposures
