The New Basel Accord - Implication for Banks

Effective risk management strategies can be implemented by integrating effective bank-level management, operational supervision and market discipline. It is also imperative for financial institutions to update their risk management practices in accordance with prevalent legislation and regulatory environment. With these aspects in mind, the Basel Committee on Banking Supervision published the Capital Adequacy Accord, also known as the Basel Accord, in 1988. The Basel Accord defined the parameters of risk management and capital adequacy for Financial Service Providers (FSPs). With the growth in the financial services sector, the Committee felt the need to update the Accord in line with new developments. As a result, it proposed the New Basel Capital Accord, also known as Basel II, in June 1999. With its new risk-sensitive framework, Basel II aims to fill the gaps left by the previous Accord. Basel II was devised to improve the soundness of the financial system by aligning regulatory capital requirement to the underlying risks of the banking industry. It encourages banks to conduct better risk management and enhance market discipline. According to the Committee, financial institutions should integrate Basel II in their operations by the year-end 2006. Efficient risk management, as outlined by Basel II, can be ensured by leveraging information technology. A more coherent architecture, would be required for process automation and integration, and cost reduction mechanisms. The chapter discusses Basel II, its framework and its impact on financial organizations.

AN OVERVIEW

Financial markets have always been sensitive towards incurring heavy losses due to either poor risk management policies or frauds - as both would reduce public confidence, which is the mainstay of the sector. Thus, banking institutions and investment firms felt the need to improve their measures for security and risk management. To achieve this, the Basel Accord was signed in 1988.

The Basel Accord was adopted by the Central Banks of over 100 countries as a basis of risk management within their banking system. It aimed to ensure an adequate level of capital in the international banking system. However, the regulatory capital requirement set by the Accord proved to be incompatible with the new sophisticated internal measures of economic capital. In addition, the Accord was unable to recognize credit risk techniques, such as collateral and guarantees. This resulted in an inflexible system and ultimately increased the risk for financial institutions. Basel II was devised to plug these gaps. A Basel II implementation allows bankers to adequately emphasize their own internal risk management methodologies. Bankers can also provide more incentives and options for risk management, thereby increasing flexibility of their systems. In addition to this, Basel II provides a variety of benefits to the banking system. These include enhanced risk management, efficient operations, and higher revenues to the banking community.

Along with the increased benefits, Basel II has also laid down some controls on the international banking system. This is primarily in the form of a higher capital requirement to underwrite mismanagement of risks and lack of infrastructural controls in many economies. The global acceptance for Basel II is not far and most banks across the world will soon come under the purview of this Accord.

Comparing the new Accord with the existing one.

Existing Accord New Accord

1. Focus on single risk. 1. More emphasis on banks' measures - own internal methodology, supervisory review and market discipline.

2. One size fits all. 2. Flexibility, menu of approaches, incentive for better risk management.

3. Broad brush structure. 3. More risk sensitivity.

After a series of revisions, Basel II has been finalized. A major part of it will be applicable by the end of 2006. During this intervening period, banks and supervisors must develop the necessary systems and processes to comply with the standards laid down by Basel II. For instance, financial institutions have to maintain a history of vital data sets built prior to the implementation date of Basel II. This will help them seamlessly "migrate" to Basel II. In addition, many countries have already started work on draft rules that would integrate Basel capital standards with their national capital regimes. The Basel II Accord aims to ensure effective risk management and security systems in the financial sector. It has undergone rigorous revisions before its framework has been finally frozen for implementation.

THE BASEL II FRAMEWORK

Basel II intends to provide more risk-sensitive approaches while maintaining the overall level of regulatory capital within the financial system. This can be achieved through its meticulously designed framework that consists of three mutually reinforcing pillars as summarized in Figure 1.

Figure 1: The Three Pillar Architecture as defined by Basel II

Source: ICFAI Research Center.

PILLAR 1

Minimum Capital Requirements

The first pillar is designed to help cover risks within a financial institution. It aims to set minimum capital requirements and defines the current amount of capital. This pillar also stresses on defining the capital amount by quantifying risks such as Credit Risk, Operational Risk and Market Risk.

MEASURING CREDIT RISK

Credit Risk defines the minimum capital required to cover exposure to customers and counter parties. The Basel II framework provides a menu of approaches in respect of credit risk. They are:

i. Standardized Approach,

ii. Internal Rating Based (IRB) Approach

a. Foundation

b. Advanced.

i. Standardized Approach: In this approach, the bank allocates a risk-weight to each of its assets and off-balance sheet positions. It then calculates a sum of risk-weighted asset values. A risk weight of 100% indicates that an exposure is included in calculation of assets at full value. The capital charge is equal to 8% of the asset value. This approach, while remaining essentially the same as in the earlier Accord, however, includes a higher sensitivity to risk. As per the earlier Accord, individual risk weights were dependent on the category of borrowers such as sovereign nations or banks. In Basel II however, these