Basel II: an introduction to the new Capital Adequacy Rules
This guide is based on an international agreement. It was last updated in September 2008.
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 Basel Committee on Banking Supervision was established in 1974 to provide a forum for banking
supervisory matters. It is made up of senior officials responsible for banking supervision or financial
stability issues in central banks and other authorities in charge of the prudential supervision of banking
businesses. Members of the Basel Committee come from Belgium, Canada, France, Germany, Italy,
Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the UK and the US.
Although the Basel Committee is not a formal regulatory authority in itself, it has great influence over
the supervising authorities in many countries. The hope is that by agreeing basic goals, the
Committee can achieve common approaches and common standards across many member countries,
without attempting detailed harmonisation of each member country's supervisory techniques.
In 1988, recognising the emergence of larger more global financial services companies, the
Committee introduced the Basel Capital Accord (Basel I). This sought to strengthen the soundness
and stability of the international banking system by requiring higher capital ratios.
Since 1988, the framework contained in Basel I has been progressively introduced not only in member
countries but also in virtually all other countries with active international banks. In June 1999, the
Committee issued a proposal for a new Capital Adequacy framework to replace Basel I. Following
extensive communication with banks and industry groups, the revised framework was issued in 2004.
Basel II, as it is known, has been or will be implemented by regulators in most jurisdictions but with
varying timelines and, in some instances, with some of its methodologies being restricted. In the
European Union, it is implemented via the EU Capital Requirements Directive.
Basel II basics
The objective of Basel II is to modernise the existing capital requirements framework to make it more
comprehensive and risk sensitive.
The Basel II framework is therefore designed to be more sensitive to the real risks that firms face than
Basel I. As well as looking at financial figures, such as how much money the firm controls, it also
considers operational risks, such as the risk of systems breaking down or people doing the wrong
things, and also market risk.
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.
Pillar 2 sets out a new supervisory review process. This requires financial institutions
to have their own internal processes to assess their overall capital adequacy in relation to
their risk profile. These are subject to review and evaluation by their supervisors.
Pillar 3 cements Pillars 1 and 2 and is designed to improve market discipline by
requiring firms to publish certain details of their risks, capital and risk management. The
intention is that these disclosures should be in line with how senior management and the
Board assess and manage the institution's risks.
This paper outlines the rules on minimum capital requirements.
Basel II and the Capital Requirements Directive
Basel II applies to internationally active banks. As noted above, in the European Union, the framework
has been implemented through the Capital Requirements Directive (CRD). The CRD affects certain
types of investment firms and all deposit takers (including banks and building societies), except credit
unions.
The framework under the CRD reflects the flexible structure and the major components of Basel II. It
has been based on the three "pillars", but has been tailored to the specific features of the EU market.
In the UK, the new capital adequacy framework has been implemented by the Financial Services
Authority (FSA) and detailed rules are contained in its Handbook.
Minimum capital requirements
Basel II requires that an institution's total regulatory capital must be at least 8% of its risk weighted
assets, based on measures of its credit risk, market risk and operational risk. This ratio is unchanged
from Basel I.
Measuring credit risk
In relation to credit risk, Basel II permits banks to use one of two methodologies. They can assess risk
using the "Standardised" Approach, which involves external credit assessments, or they can use their
own internal systems for rating credit risk. The standardised approach is similar to Basel I but risk
weights are based on credit ratings provided by external credit assessment institutions such as rating
agencies. In contrast, the foundation and advanced internal ratings based approaches reflect the fact
that many internationally active banks already have in place extremely sophisticated internal methods
for modelling, assessing and managing risk. These latter methods can be used only with the explicit
approval of the institution's supervisor.
Measuring operational risk
One of the key changes in Basel II is the addition of an operational risk measurement to the calculation
of minimum capital requirements. This has also been included in the CRD. Operational risk is defined
as the risk of loss resulting from inadequate or failed internal processes, people and systems or from
external events. This definition includes legal risk, such as exposure to fines, penalties and private
settlements. It does not, however, include strategic or reputational risk.
In calculating operational risk capital charges, Basel II sets out three different methods which may be
adopted.
The Basic Indicator Approach is the simplest of the three approaches, and will be the default option
for most firms. It applies a calculation based on the firm's income to determine its capital
requirements.
The Standardised Approach (not to be confused with the approach for credit risk of the same name)
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 advanced of the three options. Under this
approach, each firm calculates it own capital requirements, by developing and applying its own internal
risk measurement system. As with the Standardised Approach, the firm must meet certain qualifying
criteria, and the risk measurement system must be validated by the FSA before it will be allowed to
take advantage of the AMA.
Calculating market risk
As with credit and operational risk, Basel II is designed to reflect the increasingly sophisticated risk
management practices that exist in many financial institutions by offering them the opportunity to use
advanced internal models for calculating market risk. The aim is to encourage institutions to monitor
and control risk effectively, by obliging them to make a series of disclosures about their risk profiles
and regulatory capital procedures which are available to market participants. The intention is that they
strike a balance between meaningful disclosures and the need to protect confidential and proprietary
information.
Conclusion
Undoubtedly, Basel II introduces a vastly more sophisticated and risk sensitive framework. There is
even a school of thought that, had Basel II been fully implemented a few years ago, at the height of the
credit "boom", the current "crunch" may have been less severe. Nevertheless, we can expect to see
increased regulation (possibly in the form of refinements to Basel II) as governments and regulators
respond to current market turmoil.
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