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Indian Banking Today and Tomorrow
Basel Committee New Accord
BASEL II

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Indian Banking Today and Tomorrow
Basel Committee New Accord
BASEL II


[Source: Website of Basel Committee on Banking Supervision (www.bis.org)]

Basel Committee on Banking Supervision - Formulation of BASEL II - Need for
Revision of the 1988 Accord

A decade after the current accord was published in 1988, banking environment has undergone globally several changes and has turned risks inherent to banking operations more complex. There were banking crisis like the collapse of the Bearings Bank and the South Asian Crisis. The need to amend and update the current accord and make it more comprehensive to reflect the changed circumstances was then felt necessary.

Capital is envisaged as a provision or buffer to meet potential losses and to act as a motivation factor to the owners of the business to manage it prudently. The current accord recognises the importance of capital and is intended to meet and arrest the situation when the capital of a bank erodes and falls below 8% of the basket of assets measured according to perceived potential riskiness. In the new accord the extent of capital at 8% is not revised. In fact it retains the requirement of minimum capital without change. Its approach however focuses more on introducing risk-sensitivity. An effective risk analysis and risk management system are thus in-built in the second accord.

  • The 1988 accord focussed on capital adequacy of banks to shield against failure and insolvency of the banks, putting depositors to distress. The profile banking risks and risk-management tools, banking supervision and market discipline were all underwent profound changes in the decade after the current accord was introduced, necessitating its review and updation.

  • Such risks cannot be mitigated exclusively through possession of adequate capital, but it is also necessary to supplement same through effective supervision and market discipline. The second accord is therefore perceived on the strength of three pillars giving equal importance to all the three.

  • 1988 accord initiates a simple bucket approach with a flat 8% stipulation for capitalising to cover risks. Risk factor is different not only between various types of credit-assets, but also between different corporate accounts. It does not recognise credit mitigation supports like collateral and guarantee. The 'one size fits all' approach of the current accord needs to be revised to bring about 'flexibility, menu of approaches, & incentives for better risk management'

  • The current accord recognised only credit-risk arising out of potential failure counter-parties. Banks in fact are beset with several other types of risks like market risk, operational risks, liquidity and settlement risks, which when develops into hazardous level can shake the entire structure of the bank system. The failure of the Barings Bank in 1993 despite possessing capital adequacy of more than 8% on account of market/operational risks brings out the importance of effectively safeguarding against these risks

Gist of BASEL II in a nutshell

  • Threats posed by risk-prone assets held by the bank are to be counterbalanced not only through holding prescribed minimum capital, but also to be supplemented by effective supervisory review of capital adequacy and acceptance of market discipline implying public disclosure to allow market participants to assess key information about a bank's risk profile and level of capitalisation. These constitute the three pillars under the second accord. Thus the underlying implication of the new accord is greater risk sensitivity. The new accord embodies the principles of "flexibility, menu of approaches, and incentives for better risk management" as against the current accord's prescription of "one size fits all".

  • Banks with advanced risk-management tools would be permitted to use their own internal system for evaluating credit risk by the process of "internal Ratings Based Approach" instead of the standard risk weight for each category of assets. Such ratings under the standard Approach are done by external credit rating agencies. The use of IRB approach will be subject to approval by the supervisors based on the standards established by the Committee.

  • Towards extending the profile of risk-sensitivity, the new accord intends to cover all types of risks to which the banks are exposed in addition to credit risk. This category of market risks are grouped under "operational risks".

  • Operational risks are to be met through three different approaches - Basic Indicator, Standardised, and Advanced Measurement (AMA). In the basic indicator approach, the measure is a bank's average annual gross income over the previous three years. This average, multiplied by a factor of 0.15 set by the Committee, produces the capital requirement. In the standardised approach, gross income again serves as a proxy for the scale of a bank's business operations and thus the likely scale of the related operational risk exposure for a given business line. However, rather than calculate capital at the firm level as under the basic indicator approach, banks must calculate a capital requirement for each business line. This is determined by multiplying gross income by specific supervisory factors determined by the Committee. The total operational risk capital requirement for a banking organisation is the summation of the regulatory capital requirements across all of its business lines. As a condition for use of the standardised approach, it is important for banks to have adequate operational risk systems that comply with the minimum criteria outlined in CP3. In the AMA, banks may use their own method for assessing their exposure to operational risk, so long as it is sufficiently comprehensive and systematic. The extent of detailed standards and criteria for use of the AMA are limited in order to accommodate the rapid evolution in operational risk management practices that the Committee expects to see over the coming years.

  • Supervisory Review: The second pillar of the New Accord is based on a series of guiding principles, all of which point to the need for banks to assess their capital adequacy positions relative to their overall risks, and for supervisors to review and take appropriate actions in response to those assessments. These elements are increasingly seen as necessary for effective management of banking organisations and for effective banking supervision, respectively.

  • Market Discipline
  • The purpose of pillar three is to complement the minimum capital requirements of pillar one and the supervisory review process addressed in pillar two. The Committee has sought to encourage market discipline by developing a set of disclosure requirements that allow market participants to assess key information about a bank's risk profile and level of capitalisation. The Committee believes that public disclosure is particularly important with respect to the New Accord where reliance on internal methodologies will provide banks with greater discretion in determining their capital needs. By bringing greater market discipline to bear through enhanced disclosures, pillar three of the new capital framework can produce significant benefits in helping banks and supervisors to manage risk and improve stability.

Connected Reading
  1. The New Basel Capital Accord - An Explanatory Note)(Need for Revising/Improving the 1988-Accord - June 1999 Proposals)

  2. Treatment of Market Risk in the Proposed Basel Capital Accord

  3. New Capital Accord: Implications for Credit Risk Management


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