What is Basel II accord?

Basel a Swiss town, on the France & Germany border. Home of the bank for International Settlements (BIS) and seat of the committee for agreeing the accord.

The 1988 Basel Accord (Basel I) introduced a global definition of capital and set a minimum capital requirement. Its simplicity ensured it was adopted in above 100 countries.

Global goals were to reverse a downturn in bank capitalization, enhance competitive equality amongst internationally active banks and strengthen the overall stability of the banking system.

The New Basel Capital Accord (Basel II) is the product of several years of international industry consultation and provides a more sophisticated approach to Risk Management. It is now in its final draft following extensive feedback from reserve boards, regulators and global institutions.

Key Enhancements for the new accord: 1^st) Inclusion of the management and measurement of operational risk which is added to the capital requirements. 2^nd) Interest rate risk control is tightened.

There are three main disciplinary risk areas of the Basel II accord:

Market Risk (as the risk of losses in on and off balance sheet positions arising from movements market prices. Main factors contributing to market risk are equity, interest rate, foreign exchange and commodity risk).

Credit Risk (as the risk that a counter party will not settle an obligation for full value, either when due or at any time there after).

Operational Risk (as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and systems or from external events).

In Basel II accord have three pillars:

The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk, and market risk. Other risks are not considered fully quantifiable at this stage.

The credit risk component can be calculated in three different ways of varying degree of sophistication, namely standardized approach, Foundation IRB and Advanced IRB. IRB stands for "Internal Rating-Based Approach".

For operational risk, there are three different approaches - basic indicator approach or BIA, standardized approach or TSA, and the internal measurement approach (an advanced form of which is the advanced measurement approach or AMA).

For market risk the preferred approach is VaR (value at risk).

The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, pension risk, concentration risk, strategic risk, reputational risk, liquidity risk and legal risk, which the accord combines under the title of residual risk. It gives banks a power to review their risk management system.

Third pillar aims to promote greater stability in the financial system.

Market discipline supplements regulation as sharing of information facilitates assessment of the bank by others including investors, analysts, customers, other banks and rating agencies. It leads to good corporate governance. 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. It sets out the public disclosures that banks must make that lend greater insight into the adequacy of their capitalisation. when marketplace participants have a sufficient understanding of a bank’s activities and the controls it has in place to manage its exposures, they are better able to distinguish between banking organisations so that they can reward those that manage their risks prudently and penalise those that do not.

First update: September 2005 and last update: July 2009.

Source: bis.org & Wikipedia.com