Three Pillars of the Basel II Accord

While Basel I framework was confined to the prescription of only minimum capital requirements for banks, the Basel II framework expands this approach not only to capture certain additional risks in the minimum capital ratio but also includes two additional areas, viz. Supervisory Review Process and Market Discipline through increased disclosure requirements for banks.

The main purpose of Basel II framework 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 while maintaining sufficient consistency so that this does not become a source of competitive inequality amongst internationally active banks. 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 theory, Basel II attempted to accomplish this by setting up 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

Thus, Basel II framework rests on the following three mutually reinforcing pillars:

  • Pillar 1: Minimum Capital Requirements; prescribes a risk-sensitive calculation of capital requirements that, for the first time, explicitly includes operational risk along with market and credit risk.
  • Pillar 2: Supervisory Review Process; envisages the establishment of suitable risk management systems in banks and their review by the supervisory authority.
  • Pillar 3: Market Discipline and Disclosures; seeks to achieve increased transparency through expanded disclosure requirements for banks.

Three Pillars of the Basel II Accord

Pillar 1: Minimum Capital Requirements

Pillar 1 of the Basel II Accord offers distinct options for computing capital requirements for Credit Risk, Market Risk and Operational Risk.

1. Credit Risk:

Pillar 1 stipulates the following options for assigning capital to meet credit risk:

  1. Standardized Approach
  2. Internal Rating Based (IRB) Approach
  3. Advanced IRB Approach.

1. Standardized Approach

Banks may use external credit ratings by institutions recognized for the purpose by the central bank for determining the risk weight. Exposure on sovereigns and their central banks could vary from zero percent to 150 percent depending on credit assessment from ‘AAA’ to below B- . Similarly, exposure on public sector entities, multilateral development banks, other banks, securities firms and corporates also may have risk weights from 20 percent to 150 percent. Exposure on retail portfolio may carry risk weight of 75 percent.

While Basel II stipulates minimum capital requirement of 8 percent on risk weighted assets, India has prescribed 9 percent. Under Basel II exposure on a corporate with ‘AAA’ rating will have a risk weight of only 20 percent. This implies that for Rs. 100 crore exposure on a ‘AAA’ rated corporate the capital adequacy will be only Rs.1.8 crore (100 x 20% x 9%) compared to the earlier requirement of Rs. 9 crore. However, claims on a corporate with below BB- rating will carry a risk weight of 150 percent and the capital requirement will be Rs.13.50 crore (100 x 150% x 9%). Thus, a bank with a credit portfolio with superior rating may be able to save capital while banks having lower rated credit exposure will have to mobilize more capital. Risk weights can go beyond 150 percent in respect of exposures with low rating. For example, securitisation tranches with rating between BB+ and BB- may carry risk weight of 350 percent. In order to adopt standardized approach, banks will have to encourage their corporate customers to go in for ‘obligor (borrower) rating’ and get themselves rated. The central bank has to accredit External Credit Assessment Institutions (ECAI) who satisfies defined criteria of objectivity, independence, international access, transparency, disclosure, resources and credibility.

2.  Internal Ratings Based (IRB) Approach

It is also called Foundation Internal ratings Based Approach. Banks, which have developed reliable Management Information System (MIS) and have received the approval of the central bank, can use the IRB approach to measure credit risk on their own. The bank should have reliable data on Probability of Default (PD), Loss Given Default (LGD), Exposure at Default (EAD) and effective Maturity (M) to make use of IRB approach. Minimum requirements to adopt the IRB approach are:

  • Bank’s overall Credit Risk management practices must be consistent with the sound practice guidelines issued by the Basel committee and the National Supervisor.
  • Rating dimensions to include both Borrower Rating and Facility Rating and has to be applied to all asset classes.
  • The Rating Structure adopted need to have minimum 7 grades of performing borrowers and a minimum 1 Grade of non-performing borrowers and enough grades to avoid undue concentrations of borrowers in particular grades.
  • Criteria of Rating Systems to be documented and have the ability to differentiate risk, predictive and discriminatory power.
  • Assessment Horizon for PD estimation to be 1 year.
  • Use of models to be coupled with the use of human judgement and oversight.
  • Rating Assignment and Rating Confirmation to be independent.
  • The PD to be a long run average over an entire economic cycle (at least 5 years)
  • Banks should have confidence in the robustness of PD estimates and the underlying statistical analysis.
  • Data collection and IT systems to improve the predictive power of rating systems and PD estimates.
  • Validation of internal Rating systems/ Models by the Supervisor.
  • Streamlining use of credit risk mitigants and ensuring legal certainty of executed documents.

3. Advanced Internal Rating Based (IRB) Approach

Under foundation approach banks provide more of their own estimates of Probability of Default (PD) and rely on supervisory estimates for other risk components. In the case of advanced approach banks provide more of their own estimate of Loss Given Default (LGD), Exposure at Default (EAD) and effective Maturity (M), subject to meeting minimum stipulated standards.

2. Market Risk

A bank’s investment portfolio is impacted by the fluctuation in prices of securities. Even in respect of sovereign exposure there will be change in market price because of interest rate movements. When the prices of securities are marked to market, a bank may incur loss if the prices have declined. Change in interest rates, foreign exchange rates and prices of equity, corporate debt instruments and commodities may involve market risk for the bank. Mismatches in interest rates on assets and liabilities may also entail risk for the bank. The investment portfolio has to be divided into the trading book and the banking book. While the trading book has to be valued on a daily basis on mark to market basis, for the banking book, there should be frequent assessment of shock absorption capacity of the portfolio to interest rate movements.

The approaches for Market risk are Standardized Approach and Internal Model Based Approach.

3. Operational Risk

A bank also encounters risks other than on account of default by a third party or adverse market rate movements. These risks can be attributed to failed internal systems, processes, people and external events. Mistakes committed because of weak internal systems may lead to losses. Frauds may be committed on the bank by some customers, outsiders and even by employees. If a proper Know Your Customer (KYC) system is not in place, a bank may be exposed to loss of money and reputation in a punitive action by the regulators. To minimize operational risks Know Your Employee (KYE) principles are also to be observed before employees are entrusted with sensitive assignments.

The approaches for Operational Risk are Basic Indicator Approach, Standardized Approach and Advanced Measurement Approach.

Pillar 1 of the Basel II Accord envisages that banks assess credit risk, market risk and operational risk and provide for adequate capital to cover the risks.

Pillar 2: Supervisory Review Process

Compliance of requirements under Pillar 1 and providing adequate capital alone may not be enough to prevent bank failures and to protect the interests of depositors. Therefore, under Pillar 2 which deals with key principles of supervisory review, risk management guidance and supervisory transparency and accountability with respect to banking risks, including guidance relating to the treatment of interest rate risk in the banking book, credit risk (stress testing, definition of default, residual risk and credit concentration risk), operational risk, enhanced cross border communication and co-operation and securitization, supervisors are expected to evaluate how well banks are assessing their capital needs relative to their risks and to intervene where appropriate. This interaction is intended to foster an active dialogue between banks and supervisors so that when deficiencies are identified, prompt and decisive action can be taken to reduce risk or restore capital. Supervisors may focus more intensely on banks with risk profiles or operational experience, which warrants such attention.

There are the following four main areas to be treated under Pillar 2:

  1. Risks considered under Pillar 1 that are not fully captured by Pillar 1 process (e.g credit concentration risk);
  2. Those factors not taken into account by Pillar 1 process (e.g. interest rate risk in the banking book, business and strategic risk).
  3. Factors external to the bank (e.g. business cycle effects).
  4. Assessment of compliance with minimum standards and disclosure requirements of the more advanced methods under Pillar 1.

Supervisors have to ensure that these requirements are being met both as qualifying criteria and on a continuing basis.

The four key principles of supervisory review are:

Principle 1: Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels.

The five main features of a rigorous process are as follows:

  1. Board and senior management oversight;
  2. Sound capital assessment;
  3. Comprehensive assessment of risks;
  4. Monitoring and reporting; and
  5. Internal control review.

Principle 2: Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies, as well as their ability to monitor and ensure their compliance with regulatory capital ratios. Supervisors should take appropriate supervisory action if they are not satisfied with the result of this process.

Principle 3: Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum.

Principle 4: Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored.

Reserve Bank of India has implemented the risk-based supervision and has made a good beginning in implementation of the guidelines under Pillar 2 of the Basel II Accord. Internal inspections of banks in India are also tuned more towards risk-based audit.

Pillar 3: Market Discipline and Disclosures

Disclosure requirements are stipulated for banks to encourage market discipline. This will help the market participants to assess the information on capital, risk exposures, risk assessment processes and capital adequacy of the bank. Such disclosures are more important in the case of banks, which are permitted to rely on internal methodologies giving them more discretion in assessing capital requirements. Market discipline supplements regulation as sharing of information facilitates assessment of the bank by others including investors, analysts, customers, other banks and rating agencies. It also leads to good corporate governance.

Supervisors can stipulate the minimum disclosures to be made by banks. Banks can also have Board approved policies on disclosure. A transparent organization may create more confidence in the investors, customers and counter parties with whom the bank has dealings. It would also be easier for such banks to attract more capital.