Basel II A Risk Management Technique

Introduction:
June 26th, 2004 is a remarkable achievement in history of banking and finance as the central
bank governors and the heads of bank supervisory authorities in the Group of Ten (G10)
countries (Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden,
Switzerland, the United Kingdom and the United States and representatives from Luxembourg
and Spain) met and endorsed the publication of the International Convergence of Capital
Measurement and Capital Standards: a Revised Framework, the new capital adequacy
framework commonly known as Basel II. The meeting took place at the Bank for International
Settlements in Basel, Switzerland. It was prepared by the Basel Committee on Banking
Supervision, a group of central banks and bank supervisory authorities in the G10 countries,
which developed the first standard in 1988.
The Basel II Framework sets out the details for adopting more risk-sensitive minimum capital
requirements for banking organizations. The new framework reinforces these risk-sensitive
requirements by laying out principles for banks to assess the adequacy of their capital and for
supervisors to review such assessments to ensure banks have adequate capital to support their
risks. It also seeks to strengthen market discipline by enhancing transparency in banks financial
reporting.

BASEL II An Overview:
This new capital adequacy regime offers a comprehensive and more risk sensitive capital
allocation methodology for major risk categories. Basel II Framework comprises of three parts
referred to as three pillars of Accord; Pillar I which is about minimum capital requirement,
prescribed the capital allocation methodology against credit and operational risk. The capital
requirement for Market risk remains the same as envisaged under Basel I in 1996. The risk which
are not captured under pillar I, are covered in pillar II. Pillar II of the New Accord outlines the
supervisory review process of the capital adequacy of banks. It requires banks to establish a
robust risk management framework to identify, assess and manage major risks inherent in the
institution and allocate adequate capital against those risks. The supervisor has to review the
adequacy of risk management function and capital allocation mechanism against major risk
including those that are not covered under pillar I i.e. Liquidity Risk, Concentration Risk,
Interest Rate Risk in Banking Book etc. and ensures it commensurate with the size and nature of
business of the institution. The pillar III of the Accord sets out the disclosure requirement

depending upon which particular approach of Pillar I, institutions can adopt for calculating
Minimum Capital Requirement.

BASEL II:
ThenewAccord(BaselII)isbasedonthreemutuallyreinforcingpillars.

Market Risk:
Market risk is the risk that the value of an investment will decrease due to moves
in market factors. Volatility frequently refers to the standard deviation of the change in value of
a financial instrument with a specific time horizon

Basel II A Risk Management Technique

PILLAR I MINIMUM CAPITAL REQUIREMENT:

The First pillar is about minimum capital requirement. This part of the Accord outlines the level
of capital required by the bank against credit, market and operational risk based on the risk
profile of the organization. The primary objective is neither to raise nor lower on average
regulatory capital for banks however the capital requirements for a specific bank may increase or
decrease depending upon its own risk profile. A banks capital ratio will be calculated by
dividing the total capital by the sum of risk-weighted assets of credit risk, market risk and
operational risk.

Capital Adequacy Ratio (CAR) = _______________Total Capital________________________

Risk Weighted Assets (Credit Risk + Operational Risk + Market Risk)

What are Risk-Weighted Assets?

The idea of risk-weighted assets is a move away from having a static requirement for capital.
Instead, it is based on the riskiness of a bank's assets. For example, loans that are secured by a
letter of credit would be weighted riskier than a mortgage loan that is secured with collateral. On
and off-balance-sheet items are weighted for risk, with off-balance-sheet items converted to
balance-sheet equivalents (using credit-conversion factors) before being allocated a risk weight.
Risk weights are in five categories, from zero to 100 per cent. Those carrying a zero weight
include notes and coins, gold matched by gold liabilities, balances with the Central Bank and
commonwealth government securities with less than twelve months to maturity. Commonwealth
government securities with more than twelve months to maturity carry a 10 per cent risk
weighting, as do state government securities. Claims on other banks and public-sector
organizations, other than those with corporate status or which operate commercially, carry a 20
per cent risk weighting. Loans secured by a mortgage over residential property carry a 50 per
cent risk weighting and loans to companies or individuals carry a 100 per cent risk weighting.

Basel II A Risk Management Technique

Figure 1 - Risk Weighted Assets

Credit Risk:
The calculation of capital requirement against market risk remains unchanged, however the
methodologies provided for capital against credit risk are more complicated and risk sensitive.
The Accord gives a hierarchy of 3 alternative approaches for the purpose that vary in terms of
sophistication, and adoption of a particular approach depends on the risk measurement
capabilities and strength of the systems in place in a bank. A Standardized Approach will be
available for less complex banks for the credit risk calculation. This approach builds upon the
1988 Accord (risk weights determined by category of borrower) with risk weights based on
external credit ratings (with un-rated credits assigned to the 100% risk bucket.

Operational Risk:
Operational risk is an important risk facing banks and that banks need to hold capital to protect
against losses from it. Within the Basel II framework, operational risk is defined as the risk of
losses resulting from inadequate or failed internal processes, people and systems, or external
events. Operational risk was initially defined in the negative sense as any form of risk that is not
market or credit risk. This negative definition is rather vague as it does not tell us much about the

Basel II A Risk Management Technique

exact types of operational risks faced by banks today, nor does it provide banks with a proper
basis for measuring risk and calculating capital requirements.
But the committees definition includes legal risk (exposure to fines, penalties, or punitive
damages resulting from supervisory actions, as well as private settlements) but excludes strategic
(loss from poor business decision) and reputational risk (damage to an organization through loss
of its reputation). However, the Basel Committee recognizes that operational risk is a term that
has a variety of meanings and therefore, for internal purposes, banks are permitted to adopt their
own definitions of operational risk, provided the minimum elements in the Committee's
definition are included.
Although the definition has gained some acceptability in the banking industry, there are also
some analysts who believe it to be flawed, describing it as opaque, open-ended and leaving many
unanswered questions regarding the exact type of events that can be attributed to operational
losses. In particular, the somewhat abrupt manner in which legal risk is incorporated into the
definition and then left undeveloped has been the subject of criticism, as has the decision to
exclude certain risks (reputational and strategic).

PILLAR II SUPERVISORY REVIW PROCESS:

This pillar is based on the principle that capital adequacy is not just a compliance matter and it is
equally important that a bank should have a robust risk management framework. The pillar II has
two key elements:
a. A firm specific internal assessment and management of capital adequacy.
b. Supervisory review of this internal capital assessment and the robustness of risk
management processes, system and controls.
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 concept of Economic Capital under Basel II
differs from Regulatory Capital in the sense that Regulatory Capital is the mandatory capital
the regulators require to be maintained while Economic Capital is the best estimate of the
required capital that financial institutions use internally to manage their own risk and to allocate
the cost of maintaining regulatory capital among different units within the organization.
Economic Capital: Estimated capital maintained by financial institutions to
manage their own internal risk.
Regulatory Capital: Obligatory capital that regulators have to maintain.

Basel II A Risk Management Technique