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Basel II sets up risk and capital requirements, the intention being that a bank holds capital (and reserves, from here on just called capital) commensurate with the risk inherent in its loans (MD and NMD), shares and derivatives. This means the greater the risk the more capital is required to ensure its solvency; if this approach is adopted widely it contributes to financial stability, locally and internationally.
The Basel II Accord was endorsed in 2004, and rests on three pillars:
• Minimum capital requirement (addresses risk) (Pillar 1).
• Supervisory review (regulatory response to Pillar 1) (Pillar 2).
• Market discipline (promotes greater stability in the financial system) (Pillar 3).
Pillar 1: minimum capital requirement
Pillar 1 addresses the maintenance of capital required for three major risk-types a bank faces:
• Credit risk.
• Market risk.
• Operational risk.
The other risks were not considered quantifiable at that stage. There are three approaches to determining credit risk (IRB = internal ratings based):
• Standardised approach.
• Foundation IRB approach.
• Advanced IRB approach.
The standardised approach reflects the Basel I requirement, discussed earlier, but adds a new 150% rating: for borrowers with poor credit ratings. The minimum capital requirement (percentage of risk weighted assets to be held as capital) is the same as Basel I: 8%. Banks which adopt the standardised ratings approach are obliged to rely on the ratings produced by external rating agencies. For this reason many banks have adopted / are adopting the IRB approach.
The preferred approach for market risk is VaR, discussed earlier.
There are three approaches for operational risk:
• Basic indicator approach.
• Standardised approach.
• Internal measurement approach.
Pillar 2: supervisory review (regulatory response to Pillar 1)
As indicated, Pillar 2 is the regulatory response to Pillar 1, and it presents regulators much improved "tools" over those available under Basel I. It also provides a framework for managing the other bank risks: systemic risk, pension risk, concentration risk, strategic risk, reputational risk, liquidity risk and legal risk.
Pillar 3: market discipline (promotes greater stability in the financial system)
Pillar 3 promotes the sharing of bank information, which facilitates assessment of the bank by other bodies such as analysts, investors, customers, other banks and rating agencies. This amounts to peer review / market discipline, and it supplements regulation in that it leads to sound corporate governance.
Pillar 3 encourages banks to make available to the general public the details of their management procedures regarding risk, and therefore capital adequacy. The public disclosures that banks are obliged to make under Basel II enable market participants (mentioned above) to develop a good understanding of the risk profile of the bank and commensurate capital compliance. Thus, they will be able reward / punish banks (in terms of share and bond prices, i.e. the price of existing and new capital) according to risk management procedures and capital adequacy.
As mentioned above, Basel III builds on Basel II. As expressed by the BIS41: "Basel III is part of the Committee's continuous effort to enhance the banking regulatory framework... [It is] a comprehensive set of reform measures.. .to strengthen the regulation, supervision and risk management of the banking sector. These measures aim to:
• improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source
• improve risk management and governance
• strengthen banks' transparency and disclosures.
The reforms target:
• bank-level, or micro prudential, regulation, which will help raise the resilience of individual banking institutions to periods of stress
• macro prudential, system wide risks that can build up across the banking sector as well as the procyclical amplification of these risks over time.
These two approaches to supervision are complementary as greater resilience at the individual bank level reduces the risk of system wide shocks."
Table 1: Summary of Basel III requirements Source: BIS.
A summary of the Basel III requirements is presented in Table 1, and the phase-in arrangements in Table 2.
Table 2: Basel III phase-in arrangements Source: BIS.