XIM UNIVERSITY

BRM: 2022-24

Amulya Rout
Basel Committee (Basel II)

&

Basel Committee (Basel II)

Shortcomings of Basel I
Basel I with Risk-Weighted Assets of 8% to be implemented by
the end of 1992. Ultimately, this framework was introduced not
only in member countries but also in virtually all countries with
active international banks.

Basel I has following shortcomings:

1. Limited differentiation of Credit Risk (only 5)
2. Static measure of Default Risk
3. No recognition of Term Structure of Credit Risk
4. Simplified calculation of potential failure on counterparty risk
5. The lack of risk sensitivity
6. The limited collateral recognition
7. The incomplete coverage of risk portfolios
Basel II
In June 1999, the Committee issued a proposal for a new capital
adequacy framework to replace the 1988 Accord. This led to the
release of a revised capital framework in June 2004. Generally
known as "Basel II", The Revised Framework comprised three
pillars:
1. Minimum capital requirements, which sought to develop and
expand the standardized rules set out in the 1988 Accord
2. Supervisory review of an institution's capital adequacy and
internal assessment process
3. Effective use of disclosure as a lever to strengthen market
discipline and encourage sound banking practices

The New accord was called as “A review Framework on International

Convergence of Capital Measurement & Capital Standard” or
Basel II
Basel II
The new framework (Basel II) was designed to improve the way
regulatory capital requirements reflect underlying risks and to
better address the financial innovation that had occurred in
recent years.
The Basel II conceived on 3 triggers:
a. Banking crisis of 1990
b. Shortcomings of Basel I
c. Advancement of Information Technology
Basel II
The changes recommended as per Basel II aimed at rewarding and
encouraging continued improvements in risk measurement and
control. Following procedure followed:
➢ 1999: Basel Committee proposed new rules i.e. Basel II
➢ Jan 2001: Revised
➢ April 2003: Revised and Quantitative Impact Studies (QIS)
were carried out
➢ 2004: First set of rules published
➢ Nov 2005: Updated
➢ 2006: Operational Risk
➢ 2007: Implementation of Rules
Basel II
Basel II addresses two aspects:

a. Improvement of Regulatory Capital (Considering Financial

Innovation)
b. Continuous Improvement in Risk Measurement
➢ Market Risk
➢ Operational Risk
Basel II
Implementation of the Basel II Framework move forward
around the globe.
▪ A significant number of countries and banks already
implemented at the beginning of 2007.
▪ In many other jurisdictions, the necessary infrastructure
(legislation, regulation, supervisory guidance, etc) to
implement the Framework is either in place or in process.
▪ Some countries to proceed with implementation of Basel II’s
advanced approaches in 2008 and 2009.
▪ This progress is taking place in both Basel Committee member
and non-member countries.
Basel II
Basel II uses a "three pillars" concept:

▪ Minimum Capital Requirement

▪ Supervisory Review Process
▪ Market Discipline
Basel II: Three Pillars
Basel II: Pillar 1
Pillar I: Minimum Capital Requirement (MCR)

I. Capital Measurement: New Methods (Fair Value Accounting)

II. Market Risk: In Line with 1993 & 1996
III. Operational Risk: Working on new methods

Pillar I is trying to achieve

 If the bank’s own internal calculations show that they have
extremely risky, loss-prone loans that generate high
internal capital charges, their formal risk-based capital
charges should also be high
 Likewise, lower risk loans should carry lower risk-based
capital charges
Basel II: Pillar 1
Credit Risk Measurement
1. Standardized Approach: Using external rating for
determining risk weights
2. Foundation Internal Ratings Based (IRB) Approach (Bank
computes only the probability of default)
3. Advanced IRB Approach: Bank computes all risk components
(except effective maturity)
Basel II: Pillar 1

Operational & Risk Capital under Basel II

Pillar I also adds a new capital component for operational risk
(Operational risk covers the risk of loss due to system
breakdowns, fire, employee fraud or misconduct, errors in
models or natural or man-made catastrophes, among others)

a. Basic Indicator Approach

b. Standardized Approach
c. Advance Measurement Approach
Basel II: Pillar 2
Supervisory Review Process

a. Banks are advised to develop an internal capital

assessment process and set targets for capital to
commensurate with the bank’s risk profile

b. Supervisory authority is responsible for evaluating how

well banks are assessing their capital adequacy
Basel II: Pillar 3
Market Discipline
▪ Aims to reinforce market discipline through enhanced
disclosure by banks.
▪ It is an indirect approach, that assumes sufficient
competition within the banking sector.
▪ Regulatory disclosure is different from Accounting
Disclosure
▪ Adjustment made for entities
▪ Terms & conditions and main features of all Capital
Instruments
Implıcatıons of Basel II
a. The practices in Basel II represent several important
departures from the traditional calculation of bank capital
 The very largest banks will operate under a system that
is different than that used by other banks
 The implications of this for long-term competition
between these banks is uncertain, but merits further
attention
b. Basel II’s proposals rely on banks’ own internal risk
estimates to set capital requirements
➢ This represents a conceptual leap in determining
adequate regulatory capital
c. For regulators, evaluating the integrity of bank models is a
significant step beyond the traditional supervisory process
Implıcatıons of Basel II
Despite Basel II’s quantitative basis, much will still depend
on the judgment:
▪ Of banks in formulating their estimates
▪ Of supervisors in validating the assumptions used by
banks in their models
Shortcomings of Basel II
 Under the Basel II framework, regulators allow large banks with
sophisticated risk management systems to use risk assessment based on
their own models in determining the minimum amount of capital
required.
 The need to recapitalise banks reveals that the internal risk models of
many banks performed poorly and greatly under-estimated risk
exposure, forcing banks to reassess and reprice credit risk.
 A more fundamental problem is that Basel II creates perverse incentives
to underestimate credit risk.
 Because banks are allowed to use their own models for assessing risk
and determining the amount of regulatory capital, they may be tempted
to be overoptimistic about their risk exposure in order to minimise
required regulatory capital and to maximise return on equity.
 Quantitative Impact Studies” (QISs) show that bank capital requirements
will fall further for many banks when the Basel II rules are fully
implemented.
Shortcomings of Basel II
▪ The turmoil on financial markets, which has caused large banks to take
substantial losses and search for significant new capital, indicates that
Basel II should not be implemented, if at all, without first making a
number of important changes.
▪ First, we urge the Basel committee to conduct another quantitative
impact study using observations from the recent turmoil before allowing
banks to use their internal models for calculating regulatory capital.
▪ Overdependence on Rating of assets
▪ It provided incentive to a bank’s management to underestimate credit
risk.
▪ Basel II norms allowed banks to use their own models to assess risk and
determine the capital amount required to meet regulations. Most banks
chose models that were overly optimistic to build risk models that allowed
them to provide less capital for regulatory norms and to increase return
on equity.
Shortcomings of Basel II
 Basel II’s effectiveness depended a lot on a strong regulator.
 Basel II gave banks a lot of room to decide how to implement
the regulation’s spirit correctly.
 Basel II norms were not adequate in covering market risk.
 This was especially true for investment banks, which had
large exposure to market-linked securities.
 Basel II often allowed bonds issued as part of securitization
to be treated as AAA securities.

The banking industry was evolving at a rapid pace, so there was a

need for a completely new look at regulations. For this, Basel III
was introduced as we shall see in our next part of the series.
Thank You