Briefly explain the objective of Basel II, the approach taken,

how are banks intended to be strengthened globally?

Basel II: Background

In June 2004, the Basel Committee on Banking Supervision published its new Basel II
framework for bank capital adequacy, also known as the New Basel Capital Accord.

The specific aim of Basel II is to make each bank’s regulatory minimum capital
requirement much more responsive to the economic risks that the bank is actually
incurring, compared to the broad-brush formulas of the existing Accord. More broadly,
the architects of the new capital Accord have tried to give banks a strong incentive to
employ the most advanced risk measurement techniques in an attempt to replicate the
best-practice standards for risk management in the global banking industry.

Basel II addresses a wider range of risks, bank products and risk mitigants than the
existing Accord, and allows banks to choose from a menu of increasingly sophisticated
approaches to measuring risk. (The implication being that banks that adopt more
sophisticated approaches will on average gain a reduced capital requirement.)

In the run up to the publication of the Accord, most industry attention focused on the
new rules for calculating minimum capital requirements (Pillar I). However, the
supervisory review requirements (Pillar II) will require banks to create a rigorous internal
process for relating the institution’s capital adequacy to its full business and risk mix
(above and beyond any formal Pillar I requirements). Because Pillar I allows
sophisticated banks more freedom to measure their own risks, regulators will use Pillar II
to develop an even closer dialogue with banks on how risk numbers are generated and
how the bank validates and improves its risk management processes and data.

To comply with the Accord, banks are making significant and fundamental investments
to improve their internal risk processes, data infrastructure, and analytical capabilities.
As a result, Basel II compliance programs offer a rare opportunity to rethink the way
banks approach risk measurement and management, and to look again at how risk
measures can be integrated with each other and with management’s approach to
running the business.

Basel II: The 3 Pillars

Pillar 1 spells out the capital requirement of a bank in relation to the credit risk in its
portfolio, which is a significant change from the “one size fits all” approach of Basel I.
Pillar 1 allows flexibility to banks and supervisors to choose from among the
Standardized Approach, Internal Ratings Based Approach, and Securitization Framework
methods to calculate the capital requirement for credit risk exposures. Besides, Pillar 1
sets out the allocation of capital for operational risk and market risk in the trading books
of banks.

Pillar 2 provides a tool to supervisors to keep checks on the adequacy of capitalization

levels of banks and also distinguish among banks on the basis of their risk management
systems and profile of capital. Pillar2 allows discretion to supervisors to (a) link capital to
the risk profile of a bank; (b) take appropriate remedial measures if required; and (c)
ask banks to maintain capital at a level higher than the regulatory minimum.

Pillar 3 provides a framework for the improvement of banks’ disclosure standards for
financial reporting, risk management, asset quality, regulatory sanctions, and the like.
The pillar also indicates the remedial measures that regulators can take to keep a check
on erring banks and maintain the integrity of the banking system. Further, Pillar 3 allows
banks to maintain confidentiality over certain information, disclosure of which could
impact competitiveness or breach legal contracts.

In Brief:

• Pillar 1 Specifies new standards for minimum capital requirements, along with the
methodology for assigning risk weights on the basis of credit risk and market
risk; also specifies capital requirement for operational risk.

• Pillar 2 Enlarges the role of banking supervisors and gives them power to them to
review the banks’ risk management systems.

• Pillar 3 defines the standards and requirements for higher disclosure by banks on
capital adequacy, asset quality and other risk management processes.
That Can Be Gained
Basel II: The Approach Taken.
Credit Risk

Standardized Approach
The Standardized Approach specified under Basel II is more sensitive, vis-à-vis Basel I,
to the credit risks associated with an obligor. The new approach grades the credit risks
of an obligor (both on and off balance sheet items) by assigning different risk weights on
the basis of the credit ratings given by external credit assessment institutions (primarily
rating agencies). Under Basel I, on the other hand, different risk weights were assigned
to different types of obligors (sovereign, corporate or banks). To illustrate, under Basel
II, for corporate, the risk weight could vary from as low as 20% for a Aaa rated obligor
to as high as 150% for a B1 or lower rated obligor, whereas under Basel I, the risk
weight for all corporate borrowers would be a standard 100%. The key obligors that
have been differentiated under Basel II are sovereigns, corporate, banks, securities
firms, multilateral development banks, non-central government public sector enterprises,
and retail.

• Internal Ratings Based (IRB) Approach

In this approach, a bank uses its internal ratings, instead of external ratings as under
the Standardized Approach, to measure the credit risk of an obligor. The IRB Approach is
based on the measurement of unexpected loss (UL) and expected loss (EL) derived from
four key variables: probability of default (PD); Loss given default (LGD); exposure at
default (EAD); and effective maturity (M). The banks will have to estimate the potential
future loss from the exposure and assign risk weights accordingly. The IRB Approach has
been further subdivided into Foundation Approach and Advanced Approach. In
Foundation Approach, a bank would internally estimate the PD and the regulator would
provide the other three variables, whereas in Advanced Approach, the bank would be
expected to provide the other three variables as well. The implementation of IRB
approach is subject to explicit approval of the regulator who would have the discretion to
allow the bank concerned to use its internal credit rating systems for assessing credit
risk. Banks would have to satisfy the regulator about the adequacy and robustness of
their risk management systems and internal rating process, and of their competency in
estimating the key variables. The IRB Approach is more risk sensitive as compared with
the Standardized Approach and would benefit banks with improved risk management
systems, strengthening their risk assessment processes.
Operational Risk

Under Basel II, operational risk can be measured using three methods: Basic Indicator
Approach; Standardized Approach; and Advanced Measurement Approach.
• Basic Indicator Approach
The Basic Indicator Approach to measuring operational risk links the capital charge for
operational risk to a single parameter, that is, the bank’s gross annual revenue. The
capital charge is calculated as an average of the previous three years of a fixed
percentage (defined as “alpha”; set at 15% by the Basel committee) of positive gross
annual income, ignoring years in which income was either zero or negative.

• Standardized Approach
This approach is a variant of the Basic Indicator Approach. Here, the activities of the
bank are divided into eight business lines: namely corporate finance; trading & sales;
retail banking; commercial banking; payment and settlement; agency services; asset
management and retail brokerage. Within each business lines, a fixed percentage
multiplier (specified as “beta”; varies from 12% for retail brokerage to 18% for
corporate finance) is specified by Basel II. The capital charge for each business line is
calculated by multiplying the beta for each business line with its annual gross income.
The total capital charge for the bank is the three-year average of the summation of the
capital charge across each business line. The negative capital charges for a business line
can offset a positive capital charge from another business line in a year, but not across
years.

• Advanced Measurement Approach

Under this approach, the capital charge will be the risk measure generated by the bank’s
internal operational risk measurement system that uses both quantitative and qualitative
criteria. The bank would need to satisfy the regulator, that it’s Board and senior
management has an active oversight on operational risk management framework, the
operational risk management systems are sound and is implemented with integrity; and
that it has resources in the use of the approach in the major business lines as well as
control and audit functions.

Basel II: Top 10 Benefits

Top 10 Business Management Benefits Gained from Basel II Investments in
Economic Capital System
Economic Capital Systems
• Optimize your firm-wide capital management
• Risk-adjust your business line profitability analyses for strategic planning
purposes (RAROC, etc.)
• Implement Economic Capital based risk limit setting and concentration risk
management
• Improve loss reserving and provisioning in line with market demands
• Identify your top operational risks and set up ERM early warning systems
• Risk-adjust your transaction pricing and cherry pick the best deals in the market
• Target your underwriting process on the riskiest deals and improve deal
structuring
• Risk-adjust your customer profitability analysis
• Risk-adjust your incentive compensation
• Improve risk disclosure to stakeholders and rating agencies
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Basel II: Strengthening Banks Globally
Implementation of Basel II is likely to improve the risk management systems of banks as
the banks aim for adequate capitalization to meet the underlying credit risks and
strengthen the overall financial system of the country. In India, over the short term,
commercial banks may need to augment their regulatory capitalization levels in order to
comply with Basel II. However, over the long term, they would derive benefits from
improved operational and credit risk management practices.

The new accord will bring substantial change to the business of banking through the use
of more active portfolio management, risk-based performance measures and risk based
pricing.

Portfolio risk management will become more active, driven by access to more timely and
higher quality risk information, as well as by the differential capital requirements
resulting from Basel II. As Basel II impacts spread, the pricing of risks is likely to
become increasingly proactive. Economic capital will guide some, if not all product
pricing.

Having begun to calculate risk adjusted capital, 65 % of banks plan to use it for capital
attribution and 55% for performance management. Over half of the banks plan to use
economic capital in deciding incentives for business units, while only 10% will consider
trying it to individual bonuses.

The Competitive Landscape will Change: The full Impact of Basel II may take some years
to materialize, but it will contribute to a change in the competitive landscape.
Organization with well-developed risk infrastructure will gain competitive advantage.
Basel II related changes will allow the development of business models that exploit more
complete and timely risk data, as well as the better alignment between the risk and
finance functions. Also expected are:

• A greater focus on the core business

• Retreat of small firms into niche markets
• Dominance by large organizations with well developed infrastructure

It is likely that competitive advantage will be gained by those institutions that best
leverage the data, the analytics and the processes- established in part for Basel II
purposes- to improve Business Decisions.

Bibliography:

• “E Risk White Paper Series: The Ripple Effect- How Basel II will impact
institutions of all sizes”; Hans Helbekkmo, MD ERisk Consulting, Shahram
Elghanayan, MD ERisk Consulting, David Samuels, EVP ERisk, Rob
Jameson, Manageing Editor; July 2005
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• Global Basel II Survey: Basel II The Business Impact; ERNST & YOUNG;
2006

• Basel II Accord: Impact on Indian Banks; ICRA Rating Feature; March

2005
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