Basel II

Basel II, also called The New Accord (correct full name is the International Convergence of Capital Measurement and Capital Standards - A Revised Framework) is the second Basel Accord and represents recommendations by bank supervisors and central bankers from the 13 countries making up the Basel Committee on Banking Supervision to revise the international standards for measuring the adequacy of a bank's capital. It was created to promote greater consistency in the way banks and banking regulators approach risk management across national borders. The Bank for International Settlements (often confused with the BCBS) supplies the secretariat for the BCBS and is not itself the BCBS.

History

An earlier accord, Basel I, adopted in 1988, is now widely viewed as outmoded as it is risk insensitive and can easily be circumvented by regulatory arbitrage.

The Basel II deliberations began in January 2001, driven largely by concern about the arbitrage issues that develop when regulatory capital requirements diverge from accurate economic capital calculations.

With the first draft (called Consultative Paper 1) published in June 1999, further consultative papers followed together with a large quantity of other releases, Quantitative Impact Studies No2, 3 and 4, and papers, a final version was issued in June 2004, with a minor revision released in November 2005. In June 2006 was published a Comprehensive version including all Basel regulations up to this date. Implementation of the Accord is expected by 2008 in many of the over 100 countries currently using the Basel I accord.

The final version aims at:

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.

While the final accord has largely addressed the regulatory arbitrage issue, there are still areas where regulatory capital requirements will diverge from the economic.

Basel II has largely left unchanged the question of how to actually define bank capital, which diverges from accounting equity in important respects. The Basel I definition, as modified up to the present, remains in place

The Accord In Operation

Basel II uses a "three pillars" concept - (1) minimum capital requirements; (2) supervisory review; and (3) market discipline - to promote greater stability in the financial system.

The Basel I accord only dealt with parts of each of these pillars. For example: of the key pillar one risk, credit risk, was dealt with in a simple manner and market risk was an afterthought. Operational risk was not dealt with at all.

The First Pillar

The first pillar provides improved risk sensitivity in the way that capital requirements are calculated for three major components of risk that a bank faces: credit risk, operational risk and market risk. In turn, each of these components can be calculated in two or three ways of varying sophistication. Other risks are not considered fully quantifiable at this stage.

Technical terms in the more sophisticated measures of credit risk include VaR (Value at Risk), EL (Loss function) whose components are PD (Probability of Default), LGD (Loss Given Default), and EAD (Exposure At Default). Calculation of these components requires advanced data collection and sophisticated risk management techniques.

The Second Pillar

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 that a bank faces, such as name risk, liquidity risk and legal risk, which the accord combines under the title of residual risk.

The Third Pillar

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.

Criticisms

There are many criticisms that are made of Basel II. These include that the more sophisticated risk measures unfairly advantage the larger banks that are able to implement them and, from the same perspective, that the developing countries generally also do not have these banks and that Basel II will disadvantage the economically marginalized by restricting their access to credit or by making it more expensive.

A paper on home/host issues on Basel II can be dowloaded from www.nalin.ca

The first of these is a valid point, but it is difficult to see how this can be overcome. More risk sensitive risk measures were required for the larger, more sophisticated banks and, while the less sophisticated measures are simpler to calculate, due to their lower risk sensitivity they need to be more conservative.

The second criticism has elements of truth; the better credit risks will be advantaged as banks move towards true pricing for risk. Experience with these systems in the United States and the United Kingdom, however, shows that the improved risk sensitivity means that banks are more willing to lend to higher risk borrowers, just with higher prices. Borrowers previously 'locked out' of the banking system have a chance to establish a good credit history.

A more serious criticism is that the operation of Basel II will lead to a more pronounced business cycle. This criticism arises because the credit models used for pillar 1 compliance typically use a one year time horizon. This would mean that, during a downturn in the business cycle, banks would need to reduce lending as their models forecast increased losses, increasing the magnitude of the downturn. Regulators should be aware of this risk and can be expected to include it in their assessment of the bank models used.

September 2005 update

On September 30, 2005, the four US Federal banking agencies (the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision) announced their revised plans for the U.S. implementation of the Basel II accord. This delays implementation of the accord for US banks by 12 months ^*.

November 2005 update

On November 15, 2005, the committee released a revised version of the Accord, incorporating changes to the calculations for market risk and the treatment of double default effects. These changes had been flagged well in advance, as part of a paper released in July 2005.

July 2006 update

On July 4, 2006, the committee released a comprehensive version of the Accord, incorporating the June 2004 Basel II Framework, the elements of the 1988 Accord that were not revised during the Basel II process, the 1996 Amendment to the Capital Accord to Incorporate Market Risks, and the November 2005 paper on Basel II: International Convergence of Capital Measurement and Capital Standards: A Revised Framework. No new elements have been introduced in this compilation. This version is now the current version. ^*

The future

Work is apparently already underway on Basel III, at least in a preliminary sense. The goals of this project are to refine the definition of bank capital, quantify further classes of risk and to further improve the sensitivity of the risk measures.

References

http://www.bis.org/publ/bcbsca.htm Basel II: Revised international capital framework (BCBS)
http://www.bis.org/publ/bcbs107.htm Basel II: International Convergence of Capital Measurement and Capital Standards: a Revised Framework (BCBS)
http://www.bis.org/publ/bcbs118.htm Basel II: International Convergence of Capital Measurement and Capital Standards: a Revised Framework (BCBS) (November 2005 Revision)
http://www.bis.org/publ/bcbs128.pdf Basel II: International Convergence of Capital Measurement and Capital Standards: a Revised Framework, Comprehensive Version (BCBS) (June 2006 Revision)
http://www.baselalert.com Basel news and resources
http://www.globalriskregulator.com Basel news and resources
http://www.basel-ii-training.com: Basel ii Training: Impact on IT and Information Security
http://www.Basel-II.info Basel II: Portal site with studies and latest news (German language)
http://www.basel2.hk Basel II Portal for Asia-Pacific Region
Impact of Basel II on IT investments Global Data and Risk Management Survey 2005
http://www.math.ethz.ch/~baltes/ftp/Responsev3.pdf An academic response to Basel II
http://www.math.ethz.ch/~delbaen/ftp/preprints/CoherentMF.pdf Coherent measures of risk. a widely quoted paper
Daníelsson, Jón. "The Emperor Has No Clothes: Limits to Risk Modelling." Journal of Banking and Finance, 2002, 26, pp. 1273-96.

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