Basel II - An Introduction
Tuesday, January 20, 2009
Background:Capital requirements rules state that credit institutions, like banks and building societies, must at all times maintain a minimum amount of financial capital, in order to cover the risks to which they are exposed. The aim is
- to ensure the financial soundness of such institutions,
- to maintain customer confidence in the solvency of the institutions,
- to ensure the stability of the financial system at large, and
- to protect depositors against losses.
The purpose of Basel II 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.
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
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
The Basel II framework consists of three 'pillars':
- Pillar 1 sets out the minimum capital requirements firms will be required to meet to cover credit, market and operational risk.
- The rules under Pillar 2 create a new supervisory review process. This requires financial institutions to have their own internal processes to assess their capital needs and appoint supervisors to evaluate an institutions’ overall risk profile, to ensure that they hold adequate capital.
- The aim of Pillar 3 is to improve market discipline by requiring firms to publish certain details of their risks, capital and risk management.
The Committee listed a number of operational risk events which were identified (with co-operation from the industry) as having the potential to result in substantial losses:
Internal fraud – for example, intentional misreporting of positions, employee theft, and insider trading on an employee’s own account.
- External fraud – for example, robbery, forgery, cheque kiting, and damage from computer hacking.
- Employment practices and workplace safety – for example, workers compensation claims, violation of employee health and safety rules, organised labour activities and discrimination claims.
- Clients, products and business practices – for example, misuse of confidential customer information, improper trading activities on the bank’s account, money laundering, and sale of unauthorised products.
- Damage to physical assets – for example, terrorism, vandalism, earthquakes, fires and floods.
- Business disruption and system failures – for example, hardware and software failures, telecommunication problems, and power failures.
- Execution, delivery and process management – for example, data entry errors, incomplete legal documentation and unapproved access given to client accounts.
Three approaches for calculating capital adequacy
In calculating operational risk capital charges, Basel II set out three different methods which may be adopted:
- The Basic Indicator Approach
- The Standardised Approach
- The Advanced Measurement Approach
The Basic Indicator Approach is the simplest of the three approaches, and will be the default option for most firms. It applies a relatively straightforward calculation based on the firms' income to determine its capital requirements.
The Standardised Approach again relies on calculations based on income, but with different percentages applying across different business lines. To be able to take advantage of the Standardised Approach firms will have to meet certain qualifying criteria.
The Advanced Measurement Approach is the most complicated of the three options. Under this approach, each firm calculates it own capital requirements, by developing and applying its own internal risk measurement system.
Labels: Treasury
posted @ 3:30 PM,
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