BASEL ACCORDS AND ITS IMPLICATIONS

The Basel Accords refer to the banking supervision Accords i.e. recommendations on banking
laws and regulations, Basel I and Basel II issued by the Basel Committee on Banking Supervision
(BCBS). They are called the Basel Accords as the BCBS maintains its secretariat at the Bank of
International Settlements in Basel, Switzerland and the committee normally meets there.

The BASEL Committee

The Basel Committee consists of representatives from central banks and regulatory authorities
of the Group of Ten countries (The Group of Ten or G10 refers to the group of countries that
have agreed to participate in the General Arrangements to Borrow (GAB). The GAB was
established in 1962, when the governments of eight International Monetary Fund (IMF)
members—Belgium, Canada, France, Italy, Japan, the Netherlands, the United Kingdom, and
the United States—and the central banks of two others, Germany and Sweden, agreed to make
resources available to the IMF for drawings by participants, and, under certain circumstances,
for drawings by nonparticipants), plus others (specifically Luxembourg and Spain). The
committee does not have the authority to enforce recommendations, although most member
countries (and others) tend to implement the Committee's policies. This means that
recommendations are enforced through national laws and regulations, rather than as a result of
the committee's recommendations - thus some time may pass between recommendations and
implementation as law at the national level.

BASEL I
Basel I, that is, the 1988 Basel Accord, primarily focused on credit risk. Assets of banks were
classified and grouped in five categories according to credit risk, carrying risk weights of zero
ten, twenty, fifty, and up to one hundred percent (this category has, as an example, most
corporate debt). Banks with international presence are required to hold capital equal to 8 % of
the risk-weighted assets.
However, its simplicity encouraged over 100 countries across the world to not only adopt the
Basel I framework but also apply it across the entire banking segment without restricting it to
the internationally active banks. Thus, the voluntary adoption of Basel I framework by several
countries has made it, de facto, a globally accepted standard, though not all countries are fully
compliant with all the aspects.

Shortcomings with BASEL I

The Basel I accord was criticized for being a simplistic approach to setting credit risk weight and
it ignored other type of risks like hedging risks, diversification risk etc.
BASEL II
The purpose of Basel II, the second of the Basel Accords, which was initially published in June
2004, is to create an international standard that banking regulators can use when creating
regulations about how much capital banks need to put aside to guard against the types of
financial and operational risks banks face. Advocates of Basel II believe that such an
international standard can help protect the international financial system from the types of
problems that might arise should a major bank or a series of banks collapse. In practice, Basel II
attempts to accomplish this by setting up rigorous risk and capital management requirements
designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes
itself to through its lending and investment practices. Generally speaking, these rules mean that
the greater risk to which the bank is exposed, the greater the amount of capital the bank needs
to hold to safeguard its solvency and overall economic stability.

On the whole Basel II accounts for the following:-

1. Ensuring that capital allocation is more risk sensitive;

2. Separating operational risk from credit risk, and quantifying both;
3. Attempting to align economic and regulatory capital more closely to reduce the scope
for regulatory arbitrage.

BASEL ii comprises of three pillars: -

• Calculate minimum capital requirements using careful internal estimates of a range of risk
factors, such as probability of default and loss given default (Pillar I of the Accord, RAROC)

• Include a wider range of risks in their minimum capital requirement, especially exposure to
operational risks such as rogue trading, systems failure, and class action law suits (Pillar I)

• Link a comprehensive assessment of the risks they face to the amount of economic capital
they hold (Pillar II)

• Disclose risks and risk methodologies to the financial markets (Pillar III)

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.
Implications for BASEL
1) Basel II proposals rely on banks own internals internal risk estimates to set capital
requirement. Because banks have different asset classes and there is different criteria
for calculating the risk in each portfolio.

2) There has to be minimum standard set for rating system method.

Challenges for Basel II

1) Improvement in credit rating process

The challenge for banks is to re-engineer their internal credit rating system utilizing both
default probability and transaction structure, while improving the business insights that
can be gained from rating systems without disrupting underwriter knowledge and
experience.

2) A sound approach to operational risk

The Basel II regulators are keen to encourage banks to develop accurate ways to
measure operational risks, but they’ve only given broad-brush guidance about the
components of a best practice approach.
The challenge here is to work out which are most suitable tools and processes for the
specific task of calculating risk capital, and how to estimate the amount of capital to
hold against operational risks.

3) An efficient strategy for data gathering and management

To implement the Basel II advanced approaches to credit and operational risk, banks will
have to define, gather and manage large amounts of data about their transactions.