Article - New Basel Capital Accord (Basel II)

INTRODUCTION
In a bid to avoid collapses, the Basel (pronounced Basle [bɑːl] and more recently Basel ['ba:zəl]), Switzerland's third most populous city) Committee on Banking Supervision was established by the Central bank Governors of G-10 countries (which comprises 11 countries) in 1974 mainly to formulate broad supervisory standards and recommend statements of best practice for national banking supervisors. Members of the Basel Committee come from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the UK and the US. The Committee 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. The Basel Committee is not a formal regulatory authority in itself.

In 1988, recognizing 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 and is known as Basel II.

WHY NEEDED?
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. Events such as the collapse of Barings Bank and Daiwa Bank, the Y2K Bug scare, the WTC tragedy and, more recently, the Enron bankruptcy and rogue trading losses at AllFirst Bank have heightened the perception of ‘other’ risks.

In a bid to avoid collapses, the Basel Committee was established by the Central bank Governors of G-10 countries mainly to formulate broad supervisory standards and recommend statements of best practice for national banking supervisors.

The Committee can achieve common approaches and common standards across many member countries, without attempting detailed harmonization of each member country's supervisory techniques.

AIM / OBJECTIVE
The aim is to
· Ensure the financial soundness of such (financial) institutions
· Maintain customer confidence in the solvency of those institutions
· Ensure the stability of the financial system at large and
· Protect depositors against losses

By

Encouraging the use of modern risk management techniques and
Encouraging banks to ensure that their risk management capabilities are commensurate with the risks of their business.

Basel II aims at
· Separating operational risk from credit risk, and quantifying both and
· Ensuring that capital allocation is more risk sensitive

BASEL II FRAMEWORK
The Basel II framework consists of three 'pillars':

PILLAR 1 sets out the minimum capital requirements firms will be required to meet to cover the following three types of risks-

(i) Credit Risk – This component of risk can be calculated in three different ways of varying degree of sophistication, namely Standardized Approach, Foundation IRB and Advanced IRB. IRB stands for “Internal Ratings Based” approach.

(ii) Market Risk – For market risk, the preferred approach is VaR (Value at Risk)

(iii) Operational Risk - 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. For Operational Risk, there are three different approaches - Basic Indicator Approach (BIA), Standardized Approach, and Advanced Measurement Approach (AMA).

A brief explanation of these approaches is given as an appendix.

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. It also provides a framework for dealing with all the other risks a bank may face, such as liquidity risk and legal risk, which the accord combines under the title of residual risk.

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 third pillar greatly increases the disclosures that the bank must make. This is designed to allow the market to have a better picture of the overall risk position of the bank and to allow the counterparties of the bank to price and deal appropriately. The purpose of pillar three is to complement the minimum capital requirements of pillar one and the supervisory review process addressed in pillar two.

BASEL I vs. BASEL II
After having a look at the Basel II framework, let’s look at how it is different from Basel I. One of the key changes in Basel II is the addition of an operational risk measurement to the calculation of minimum capital requirements. Previously, regulators' main focus was on credit risk and market risk. Other risks are presumed to be covered implicitly through the treatments of these two major risks. In Basel II, operational risk events which were identified (with co-operation from the industry) as having the potential to result in substantial losses are:
· 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, organized 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 unauthorized 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.

These risks were not considered exclusively earlier. Naturally, operational risk was one area which was expected to increase capital requirement for the banks.

THE INDIAN SCENARIO
The Reserve Bank had announced in July 2004 that banks in India will initially adopt the Standardized Approach (SA) for credit risk and the Basic Indicator Approach (BIA) for operational risk. The prime considerations while deciding on the likely approach included the cost of implementation and the cost of compliance. The methodology for computing the capital requirement under the Basic Indicator Approach was explained to banks.

CHALLENGES FOR INDIAN BANKS
(i) The main challenge is to avoid an underestimation of the complexities involved.

(ii) Another challenge is data management. According to the survey, private sector banks may have an edge over public sector entities in data management as most public sector banks are still in the process of rolling out core banking solutions across their branches, and the standardization of data residing in myriad systems across various branches was proving to be challenging.

(iii) Other challenges are process standardization, cost control, standardizing and storing data, and acquiring the necessary skill sets.

The RBI extended the deadline from March 31, 2007 to March 31, 2008, ‘taking into account the state of preparedness of the banking system’ to provide banks more time to put in place appropriate systems.

Banks should use this additional time to align their Basel programme with other risk management initiatives, gather better quality loss data, train their staff, and manage the change process. These factors are critical to the success of this complex project.

Among the reasons for existence of Basel II are to bring competitive advantage to those financial institutions that can reshape their operations, optimize the capital structure and allocations and align the internal processes with the external compliance standards. The effect of implementing Basel II would not only improve the shareholder perception and values but also enhance the reputation and image of the banks.

SCOPE FOR IT COMPANIES
Opportunities for IT companies exist mainly in the areas of operational risks in terms of technology support for internal ratings based credit and operational risk approach, database technology and integration with front-office decision tools, areas of data collection, tracking and monitoring, analysis and reporting, risk management system, asset and liability management system, cash liquidity management and business intelligence engine.

According to one consultant, implementing Basel II requirements would require fresh investments in IT by banks and banking product companies, as it involves developing new solutions and enhancing existing solutions. It will also require a higher level of integration between different systems, for example, applications such as credit decision, application processing, risk rating, transaction systems, collateral management — all need to integrate to be able to meet the Basel II requirements.

From the IT perspective, opportunities exists in the first two pillars, that is minimum capital requirements and supervisory review.

FUTURE
Work is apparently already underway on Basel III, at least in a preliminary sense. The goals of this project are to refine the definition of bank capital, quantify further classes of risk and to further improve the sensitivity of the risk measures.

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APPENDIX

For those who are interested in methods of calculating various types of risks, here they are:
Credit Risk
The Standardized Approach is similar to the Basel I accord in that banks are required to slot their credit exposures into supervisory categories based on observable characteristics of the exposures (e.g. whether the exposure is a corporate loan or a residential mortgage loan). The standardized approach establishes fixed risk weights corresponding to each supervisory category and makes use of external credit assessments to enhance risk sensitivity compared to the current Accord. The risk weights for sovereign, inter-bank, and corporate exposures are differentiated based on external credit assessments.

The IRB approach to credit risk, which includes two variants: a foundation version and an advanced version. The IRB approach differs substantially from the standardized approach in that banks’ internal assessments of key risk drivers serve as primary inputs to the capital calculation. Because the approach is based on banks’ internal assessments, the potential for more risk sensitive capital requirements is substantial. However, the IRB approach does not allow banks themselves to determine all of the elements needed to calculate their own capital requirements. Instead, the risk weights and thus capital charges are determined through the combination of quantitative inputs provided by banks and formulas specified by the Committee.

Market Risk
Value at risk (VaR) is a measure of how the market value of an asset or of a portfolio of assets is likely to decrease over a certain time period under usual conditions. VaR has three parameters:
(i) The time horizon (period) to be analyzed (i.e. the length of time over which one plans to hold the assets in the portfolio - the "holding period").
(ii) The confidence level at which the estimate is made. Popular confidence levels usually are 99% and 95%.
(iii) The unit of the currency which will be used to denominate the value at risk(VaR).

Operational Risk
The Basic Indicator Approach is the simplest approach, 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. This approach requires the bank's average annual gross income over the previous three years to be multiplied by a factor (15 per cent for India) to determine the capital requirement for operational risk.

The Standardized Approach again relies on calculations based on income, but with different percentages applying across (eight) different business lines. To be able to take advantage of the Standardized Approach firms will have to meet certain qualifying criteria.

The Advanced Measurement Approach(AMA) 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. As with the Standardized 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. Some of the important criteria are:
· Well-developed and well-documented risk management systems fully integrated into the day-to-day risk management process of the bank;
· A system of regular reporting of operational risk exposures and loss experience to business unit management and the board of directors;
· Maintaining rigorous procedures for operational risk model development and independent model validation;
· Capability to track loss data, to each business line, and access external data bases of loss incidents where appropriate internal data are not available.

LINKS
For nitty-gritties of Basel Capital Accord visit:
http://www.bis.org/bcbs/cp3ov.pdf

For Basel II Accord Key Terms visit:
http://www.competencesoftware.net/glossword/index.php?a=list&d=1
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Rahul Maheshwari
(MBA Batch of 2008)