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Introduction
The Basel Accords refer to the banking supervision Accords (recommendations on banking regulations)Basel I, Basel II and Basel IIIissued by the Basel Committee on Banking Supervision (BCBS). They are called the Basel Accords as the BCBS maintains its secretariat at the Bank for International Settlements in Basel, Switzerland and the committee normally meets there. History of Basel Regulatory capital requirement is crucial in reducing the risk of insolvency, and the damage for banks and financial institutions worldwide. In 1988, the Basel Committee for Banking Supervision defined credit risk and the minimum amount of capital that should be held by the bank. In 1998, the Basel Committee incorporated market risk into the framework. This classification was ratified by over 100 signatories within the G-10 countries and is still used today to define the minimum amount of capital a bank must hold to cover loss arising from obligor default. The accord required that banks must hold a minimum of 8% capital. The figure of 8% is not changed anywhere however the considerations to arrive at this figure have radically changed. The reason was simple Banking, risk management practices; supervisory approaches and financial markets have seen a sea change over the years. Recent operational risk failures in financial institutions around the globe have accentuated the dangers of poor risk management. This was the fillip for Basel II, a new accord that has a more risk sensitive framework.
BASEL II
Basel II is the second of the Basel Accords, (now extended and effectively superseded by Basel III), which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. As the Basel II Capital accord continues to evolve , the Basel Committee on banking supervision moves closer to its goal of aligning banking risks and their management with capital requirements. By redefining how banks worldwide calculate regulatory capital and report compliance to regulators and the public. Basel II is intended to improve safety and soundness in the financial system by placing increased emphasis on banks own internal control and risk management. Processes and models, the supervisory and review processes, and market discipline. Basel II substantially changes the treatment of credit risk and also requires that banks have sufficient capital to cover operational risks. It also imposes qualitative requirements on the management of all risks as well as new disclosures. Basel II is scheduled to be implemented by various country bank regulators by the end of 2006, but banks must begin compliance efforts now if they are to strengthen their risk management capabilities and gather the extensive data that is required in some cases. They should make these efforts despite uncertainty about how local regulators will ultimately apply the New Accord to their regulatory capital requirements.
Objective
The final version aims at: 1. Ensuring that capital allocation is more risk sensitive; 2. Enhance disclosure requirements which will allow market participants to assess the capital adequacy of an institution; 3. Ensuring that credit risk, operational risk and market risk are quantified based on data and formal techniques; 4. 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 capital. 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.
Supervisory Review
Supervisory Review
Pillar II defines the process for supervisory review of an institutions risk management framework and, ultimately, its capital adequacy. It sets out specific oversight responsibilities for the board and senior management, thus reinforcing principles of internal control and other corporate governance practices established by regulatory bodies in various countries worldwide. According to the Basel Committee, The [New Accord] stresses the importance of bank management developing an internal capital assessment process and setting targets for capital that are commensurate with the banks particular risk profile and control environment. Supervisors would be responsible for evaluating how well banks are assessing their capital adequacy needs relative to their risks. This internal process would then be subject to
supervisory review and intervention, where appropriate. As a consequence, the supervisor may require, for example, restrictions on dividend payments or the immediate raising of additional capital. The key principles of Supervisory review 1. Banks should have the process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels. 2. Intervention at the early stage to prevent capital from declining to below benchmark level. 3. Review of internal capital adequacy assessment and strategy 4. Assessment of overall capital in relation with risk profile. Internal Capital Adequacy Assessment Process (ICAAP) is the result of Pillar II of Basel II accords
Market Discipline
This pillar aims to complement the minimum capital requirements and supervisory review process by developing a set of disclosure requirements which will allow the market participants to gauge the capital adequacy of an institution. Market discipline supplements regulation as sharing of information facilitates assessment of the bank by others including investors, analysts, customers, other banks and rating agencies which leads to good corporate governance. The aim of pillar 3 is to allow market discipline to operate by requiring institutions to disclose details on the scope of application, capital, risk exposures, risk assessment processes and the capital adequacy of the institution. It must be consistent with how the senior management including the board assess and manage the risks of the institution.
Those with a possible advantage: Prime mortgage customers Well-rated entities High-quality liquidity portfolios Collateralized and hedged exposures Small and medium-sized businesses Those with a possible disadvantage: Higher credit risk individuals Uncollateralized credit Specialized lending (in some cases)
Basel III
BASEL III is a global regulatory standard on bank capital adequacy, stress testing and market liquidity risk agreed upon by the members of the Basel Committee on Banking Supervision in 2010-11.[1] This, the third of the Basel Accords was developed in response to the deficiencies in financial regulation revealed by the late-2000s financial crisis. Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage. For instance, the change in the calculation of loan risk in Basel II which some consider a causal factor in the credit bubble prior to the 2007-8 collapse: in Basel II one of the principal factors of financial risk management was out-sourced to companies that were not subject to supervision: credit rating agencies. Ratings of creditworthiness and of bonds, financial bundles and various other financial instruments were conducted without supervision by official agencies, leading to AAA ratings on mortgage-backed securities, credit default swaps and other instruments that proved in practice to be extremely bad credit risks. In Basel III a more formal scenario analysis is applied (three official scenarios from regulators, with ratings agencies and firms urged to apply more extreme ones). The OECD estimates that the implementation of Basel III will decrease annual GDP growth by 0.05 to 0.15 percentage point.Outside the banking industry itself, criticism was muted. Bank directors would be required to know market liquidity conditions for major asset holdings, to strengthen accountability for any major losses.