Basel II summary

The Basel II Accord was introduced following substantial losses in the international markets since 1992, which were attributed to poor risk management practices. The Basel II Accord makes it mandatory for financial institutions to use standardized measurements for credit, market risk, and operational risk. However, different levels of compliance allow financial institutions to pursue advanced risk management approaches to free up capital for investment.

Basel II uses a three-pillars concept:

• Pillar 1 - minimum capital requirements (addressing risk)
  The first pillar deals with ongoing maintenance of regulatory capital that is required to safeguard against the three major components of risk that a bank faces - Credit Risk, Operational Risk, and Market Risk.
  • Credit Risk component can be calculated in three different ways of varying degree of sophistication, namely Standardized Approach, Foundation Internal Rating-Based (IRB) Approach, and Advanced IRB Approach.
  • For Operational Risk, there are three different approaches:
  • Basic Indicator Approach (BIA)
  • Standardized Approach (STA)
  • Internal Measurement Approach, an advanced form of which is the Advanced Measurement Approach (AMA)
  • For Market Risk, Basel II allows for Standardized and Internal approaches. The preferred approach is Value at Risk (VaR).
  • As the Basel II recommendations are phased in by the banking industry, it moves from standardized requirements to more refined and specific requirements that are tailored for each risk category by each individual bank. The benefit for banks that do develop their own bespoke risk measurement systems is that they are rewarded with potentially lower risk capital requirements.
• Pillar 2 - supervisory review

  This is a regulatory response to the first pillar, giving regulators better 'tools' over those previously available. It also provides a framework for dealing with Pension Risk, Systemic 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

  This pillar aims to encourage market discipline by developing a set of disclosure requirements, which allow market participants to assess key pieces of information on the scope of application, capital, risk exposures, risk assessment processes, and hence the capital adequacy of the institution. Market Discipline supplements regulation, as sharing of information facilitates assessment of the bank by others (including investors, analysts, customers, other banks, and rating agencies) which leads to good corporate governance. By providing disclosures that are based on a common framework, the market is effectively informed about a bank’s exposure to those risks, and provides a consistent and understandable disclosure framework that enhances comparability. These disclosures are required to be made at least twice a year, apart from qualitative disclosures that provide a summary of the general risk management objectives and policies, which can be made annually. Institutions are also required to create a formal policy on what will be disclosed and controls around them along with the validation and frequency of these disclosures. In general, the disclosures under Pillar 3 apply to the top consolidated level of the banking group to which the Basel II framework applies.