BASEL II Primer: New Capital Adequacy Framework for Banks

Risk means the possibility that both expected and unexpected events can have an adverse impact on a bank’s capital and earnings. While the expected losses are taken care of through suitable pricing mechanism, the unexpected losses are to be borne by the bank itself with the help of requisite capital, which is reflected in Capital Adequacy Ratio.

The size of this regulatory capital was determined by Based Accord (Basel I) earlier and now by Basel II Framework. Basel Committee on Banking Supervision (BCBS) is responsible to frame these rules; the committee has members from various (13) countries that are represented by their respective central banks or equivalent authority.

The objective of Basel II is to introduce a more risk-sensitive capital framework with incentives for good risk management practices. For inculcating such practices a multipronged approach would be required to meet the challenges of maintaining capital at the regulator-mandated level in the face of recognizing risk factors in the banking sector. Banks are exposed to severe competition compelling them to encounter financial and non-financial risks. Business grows mainly by taking risks – and hence the entity must strike a trade off between the two as risk and uncertainty form an integral part of banking operation.

Basel II will impact the entire spectrum of banking, including corporate finance, retail banking, asset management, payments and settlements, commercial banking, trading and sales, retail brokerage and agency and custody services. 

Need of Basel Accord

Banking industry is the backbone of any country's economy; the sounder it is, the better the performance of the financial markets and the economy as a whole. Just like any other industry, banking industry is susceptible to various types of risks which might occasionally occur in losses, and at times they tend to be so severe that they take entire  firm down with them. To hedge against such risks, banks keep a minimum buffer of equity and provisions (regulatory capital), given a certain amount of various kinds of risks. 

Objectives of Basel Accord

• Ensuring that capital allocation is more risk sensitive;
• Separating operational risk from credit risk, and quantifying both;
• Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.

Basel II Framework

Basically, the Basel II Framework is known as having a "three mutually reinforcing pillar" approach, and these three pillars are: -

• Minimum Capital Requirements 

• Supervisory Review of Capital Adequacy 

• Market Discipline 

The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: credit risk, operational risk and market risk. 

The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, pension risk, concentration risk, strategic risk, reputation risk, liquidity risk and legal risk, which the accord combines under the title of residual risk.

The third pillar greatly increases the disclosures that the bank must make. This is designed to allow the market to have a better picture of the overall risk position of the bank and to allow the counterparties of the bank to price and deal appropriately.

What I thinks......

The New Accord’s risk management requirements are likely to prompt significant changes in the core business of an individual bank as well as in its organizational structure. Under Basel II, the “outputs” of better management of credit and operational risk will be the “inputs” of an economic capital model by which banks can allocate capital to various functions and transactions depending on risk. This new focus on risk will likely have broad implications for institutions not obliged to comply with Basel II as well as customers and the capital markets.

Aside from new or altered methods that must be employed, the new capital requirements will also drive change in resource needs, processes, and IT system architecture. These changes could ultimately pose broad challenges for a bank’s board of directors and its senior management, who are charged with new risk management and reporting responsibilities under the New Accord. These senior leaders will need to consider how Basel II compliance could (or should) integrate with other efforts they are making to improve corporate governance.