Basel -2: Basel 2 comprises of second set of norms recommended by Basel Committee on Banking Supervision (BCBS) on banking regulations. The requirements for Basel 2 norms were the result of two triggers: – the banking crises of the 1990s on the one hand, and the criticisms of Basel I itself on the other.
In the year 1999, BCBS proposed a new set of norms, which were far more through on capital adequacy. The accord was formally known as A Revised Framework on International Convergence of Capital Measurement and Capital Standards (Basel 2). The new framework was designed to improve the way regulatory capital requirements reflect the underlying risks for addressing the recent financial innovation. Also, this framework focuses on the continuous improvements in risk measurement and control.
The Pillar framework from Basel -1 was retained with much more stringent criteria on capital adequacy and credit risk.
Pillar 1 – Minimum Capital Requirements: A primary mandate of this accord was to widen the scope of regulation. This is achieved by including on a fully consolidated basis, any holding company that is the parent entity within a banking group to ensure that it captures the risk of the whole banking group. This preempts the possibility that a bank will conceal risk-taking by transferring assets to other subsidiaries.
Credit Risk: Basel II aimed to measure the risk-weighted assets (RWAs) of a bank more carefully. This revised framework placed forth three methodologies to determine the risk rating of a bank’s assets – the Standardized Approach and two Internal Ratings Based Approaches.
The Standardized Approach directed banks to use ratings from external credit rating agencies to compute capital requirements commensurate with the level of credit risk.
Basel II leans towards the two Internal Ratings Based Approaches – the Foundation IRB (abbreviated as F-IRB) and the Advanced IRB (abbreviated as A-IRB). Foundation IRB gives banks the freedom to develop their own models to ascertain risk weights for their assets. These are, however, subject to the approval of the banking regulator. Further, the regulators provide the model assumptions – loss given default (LGD), exposure at default (EAD), and effective maturity (M). Banks are, however, allowed to use their own estimates of the probability of default (PD).
Advanced IRB is fundamentally the same as Foundation IRB, except that banks are free to use their own assumptions (of LGD, EAD and M) in the models they develop. Understandably, this approach can be used only by a select set of banks.
Operational Risk: Basel II introduces measures to assess and reduce operational risks. Three methods for this measurement are proposed – Basic Indicator Approach, Standardized Approach and Advanced Measurement Approach.
Basic Approach: The Basic Indicator Approach suggests that banks hold 15 percent of their average annual gross income (over the past three years) as capital. On the basis of risk assessments of individual banks, regulators may adjust the 15 percent threshold.
Standard Approach: The Standardized Approach basically splits a bank into compartments based on its business lines. The idea is that business lines with lower operational risk (asset management, for instance) would translate into lower reserve requirements.
Advanced Measurement Approach: The Advanced Measurement Approach gives banks the freedom to perform their own computations for operational risk.
Market Risk: Market risk is simply the risk of loss as a result of movements in the market prices of assets. In this regard, Basel II makes two clear distinctions – one in respect of asset categories, and the other regarding types of principal risks. In terms of assets, fixed income products are treated differently as compared to others. In terms of principal risk, there are two segments specifically identified – interest rate risk and volatility risk.
Total Capital Adequacy: Once the asset base is adjusted based on credit risk, and reserves in respect of operational risk and market risk are computed, a bank can readily calculate its reserve requirements to meet the capital adequacy norms of Basel II. As in the case of Basel I, a bank must maintain equal amounts of Tier 1 and Tier 2 capital reserves. Further, the reserve requirement continued at 8 percent.
Final Reserve Requirements may be calculated as:
Reserves = 0.08 * Risk-Weighted Assets + Operational Risk Reserves + Market Risk Reserves
Pillar 2 – Supervisory review: Pillar II focuses on the aspect of regulator-bank interaction. Specifically, it empowers regulators in matters of supervision and dissolution of banks. It also provides a framework for dealing with 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.
Pillar 3 – Market Discipline: Pillar III aims to induce discipline within the banking sector of a country. Basel II suggested that, disclosures of the bank’s capital and risk profiles which were shared solely with regulators till this point should be made public.
The Three Pillars for Basel 2 have been given in summarized below: