Basel II was developed to ensure that there is less risk on capital allocation, unraveling operational risk from credit risk and quantifying both, and attempting to align economic and regulatory capital more closely to reduce the possibility of regulatory arbitrage.
1.2 The pillars used in Basel II
The Basel II International Convergence of Capital Measurement and Capital Standards, the reviewed framework is based on three main pillars.
1.2.1 First Pillar Minimum Capital Requirements
The first principle of this revised framework comprises the minimum capital requirements necessary to cater for the three fundamental risks that a bank faces in business operations. These consist of Credit risk, Capital risk and Operational risk, which shall be further expounded below:
The internal rating based model permits banks to develop their own experimental model to determine the probability of default for isolated clients or segmented customer groups. Adoption of the regulators loss given default and other set parameter is necessary.
Under the Basic Indicator Approach, banks are required to hold capital for operational risk corresponding to the average over a three year time frame of a fixed percentage of a positive annual gross income.
1.2.2 Second Pillar Supervisory Review Process
The basic principles of this pillar of the Basel II International Convergence of Capital Maintenance and Capital Standards revised framework include the supervisory review and transparency, risk management direction and accountability of the adoption of the aforementioned revised concept.
The supervisory review process is designed not only to ensure that targeted banks possess proper capital to sustain all the risks in their business, but also to induce banks to develop and maintain better risk management techniques in monitoring and assessing their respective risks. There are the following four key principles of the supervisory review:
The Committee has also identified the following vital issues that banks and supervisors are required to focus on: interest rate risk in the banking book, credit risk and operational risk. It is also recognized that since supervision of banks is not an exact science, discretionary measures and procedures ought to be adopted. The importance of transparency, accountability and proper cross-border communication and cooperation arise in this respect.
1.2.3 Third Pillar Market Discipline
Disclosure requirements are highly focused in this final pillar in order to induce the market to perceive a better picture of the general risk position of the banks and thus sustain counterparties of the bank to price and deal correctly. This last pillar is also aimed to compliment the previous two important areas discussed.
The Committee recognizes the factor that the supervisor is a key player in the achievement of disclosure requirements. Such market discipline is a vital feature for a safe and sound banking environment. This safe environment arises from additional information disclosed in periodic and annual financial reports. The methods that can be adopted in order to induce these disclosure requirements may vary depending on the countries legislation and present practices. Examples that come to mind are through penalties, advices and more.
The Basel II International Convergence of Capital Maintenance and Capital Standards revised framework also notes that such necessary disclosure requirements ought to be practical and in line with accounting standards and other relevant regulations. For instance, management is allowed to use his discretion in the determination of the location and medium of these disclosures. Materiality, frequency and proprietary and confidential information are also considered in order to minimize such reporting costs and ensure that organizations are not put in any competitive disadvantage with the application of such information requirement.
The disclosure requirements demanded encompass a number of factors, such as:
Bank for International Settlements (2004). Basel II International Convergence of Capital Maintenance and Capital Standards: a Revised Framework (on line). Available from: http://www.bis.org/publ/bcbs107.htm (Accessed 16th April 2007).
Basel Committee on Banking Supervision (2004). International Convergence on Capital Measurement and Capital Standards. Switzerland: Bank for International Settlements