Professional Documents
Culture Documents
Basel II - A Risk Management Technique
Basel II - A Risk Management Technique
Introduction:
June 26th, 2004 is a remarkable achievement in history of banking and finance as the central
bank governors and the heads of bank supervisory authorities in the Group of Ten (G10)
countries (Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden,
Switzerland, the United Kingdom and the United States and representatives from Luxembourg
and Spain) met and endorsed the publication of the International Convergence of Capital
Measurement and Capital Standards: a Revised Framework, the new capital adequacy
framework commonly known as Basel II. The meeting took place at the Bank for International
Settlements in Basel, Switzerland. It was prepared by the Basel Committee on Banking
Supervision, a group of central banks and bank supervisory authorities in the G10 countries,
which developed the first standard in 1988.
The Basel II Framework sets out the details for adopting more risk-sensitive minimum capital
requirements for banking organizations. The new framework reinforces these risk-sensitive
requirements by laying out principles for banks to assess the adequacy of their capital and for
supervisors to review such assessments to ensure banks have adequate capital to support their
risks. It also seeks to strengthen market discipline by enhancing transparency in banks financial
reporting.
BASEL II An Overview:
This new capital adequacy regime offers a comprehensive and more risk sensitive capital
allocation methodology for major risk categories. Basel II Framework comprises of three parts
referred to as three pillars of Accord; Pillar I which is about minimum capital requirement,
prescribed the capital allocation methodology against credit and operational risk. The capital
requirement for Market risk remains the same as envisaged under Basel I in 1996. The risk which
are not captured under pillar I, are covered in pillar II. Pillar II of the New Accord outlines the
supervisory review process of the capital adequacy of banks. It requires banks to establish a
robust risk management framework to identify, assess and manage major risks inherent in the
institution and allocate adequate capital against those risks. The supervisor has to review the
adequacy of risk management function and capital allocation mechanism against major risk
including those that are not covered under pillar I i.e. Liquidity Risk, Concentration Risk,
Interest Rate Risk in Banking Book etc. and ensures it commensurate with the size and nature of
business of the institution. The pillar III of the Accord sets out the disclosure requirement
depending upon which particular approach of Pillar I, institutions can adopt for calculating
Minimum Capital Requirement.
BASEL II:
ThenewAccord(BaselII)isbasedonthreemutuallyreinforcingpillars.
Market Risk:
Market risk is the risk that the value of an investment will decrease due to moves
in market factors. Volatility frequently refers to the standard deviation of the change in value of
a financial instrument with a specific time horizon
Credit Risk:
The calculation of capital requirement against market risk remains unchanged, however the
methodologies provided for capital against credit risk are more complicated and risk sensitive.
The Accord gives a hierarchy of 3 alternative approaches for the purpose that vary in terms of
sophistication, and adoption of a particular approach depends on the risk measurement
capabilities and strength of the systems in place in a bank. A Standardized Approach will be
available for less complex banks for the credit risk calculation. This approach builds upon the
1988 Accord (risk weights determined by category of borrower) with risk weights based on
external credit ratings (with un-rated credits assigned to the 100% risk bucket.
Operational Risk:
Operational risk is an important risk facing banks and that banks need to hold capital to protect
against losses from it. Within the Basel II framework, operational risk is defined as the risk of
losses resulting from inadequate or failed internal processes, people and systems, or external
events. Operational risk was initially defined in the negative sense as any form of risk that is not
market or credit risk. This negative definition is rather vague as it does not tell us much about the
exact types of operational risks faced by banks today, nor does it provide banks with a proper
basis for measuring risk and calculating capital requirements.
But the committees definition includes legal risk (exposure to fines, penalties, or punitive
damages resulting from supervisory actions, as well as private settlements) but excludes strategic
(loss from poor business decision) and reputational risk (damage to an organization through loss
of its reputation). However, the Basel Committee recognizes that operational risk is a term that
has a variety of meanings and therefore, for internal purposes, banks are permitted to adopt their
own definitions of operational risk, provided the minimum elements in the Committee's
definition are included.
Although the definition has gained some acceptability in the banking industry, there are also
some analysts who believe it to be flawed, describing it as opaque, open-ended and leaving many
unanswered questions regarding the exact type of events that can be attributed to operational
losses. In particular, the somewhat abrupt manner in which legal risk is incorporated into the
definition and then left undeveloped has been the subject of criticism, as has the decision to
exclude certain risks (reputational and strategic).